By describing the evolution of Warren Buffett (Trades, Portfolio)’s thinking about “fair companies at wonderful prices” and “wonderful companies at fair prices,” as well as Joel Greenblatt (Trades, Portfolio)’s quantification of companies and prices (the "Magic Formula"), Tobias Carlisle built his foundation and was ready to tell readers about his investment model.
In chapter six of his book, "The Acquirer's Multiple: How the Billionaire Contrarians of Deep Value Beat the Market," Carlisle explained, “The Acquirer’s Multiple is an industrial-strength PE multiple.” He said the idea came from the analytics used by corporate raiders and buyout operators of the 1980s.
These “acquirers” used this multiple to find whole companies that could be taken over cheaply: “Where most investors only look at profits, the corporate raiders looked to see what a company owned. They used it to find treasure hidden in plain sight on corporate balance sheets.”
It is the idea that acquirers could buy the company, sell assets to raise cash and then pay out or redirect that cash — often into their own pockets. To do this successfully, the raiders had to identify hidden traps and debts as well as hidden assets.
For his model, the industrial strength price-earnings ratio, Carlisle divided enterprise value by operating earnings:
Or, “Think of the enterprise value as the price you pay and operating earnings as the value you get.” Logically, then, the less you pay for the Acquirer’s Multiple, the more value you get for the price.
Looking more deeply into enterprise value and operating earnings, we start by distinguishing between market capitalization and enterprise value. This image from the GuruFocus summary page for Tesla (TSLA, Financial) shows the dollar difference between the two measures:
Why are the two different? Because enterprise value includes debt as well as cash. Companies use both cash and debt to buy assets that should produce earnings greater than the cost of capital or interest payments (theoretically, at least).
In the case of Tesla shown above, we can see that shareholders have $51.45 billion in capital, and to supplement that the company has $9.12 billion in debt financing available, for a total of $60.57 billion. If a company’s listing showed market cap and enterprise value as equal, then we would know the company had no debt.
As Carlisle has put it, “Enterprise value tells us how much it costs to buy all of the stock and all of the debt (and other things like debt).” Those “other things” included preferred shares and minority interests.
The importance of enterprise value would have been felt by investors who put their capital into General Motors (GM, Financial) in 2005, when its market cap was $17 billion. Investors who failed to look behind the market cap would not have seen its $287 billion of debt, one of the main reasons it filed for bankruptcy in 2009.
Turning to operating earnings, Carlisle pointed out that Buffett often writes about “operating earnings before interest and taxes” and that his main focus is on building operating earnings. He defines operating earnings as earnings minus capital gains, special accounting items and major restructuring charges.
Since operating earnings do not appear in financial statements, analysts usually calculate them using the formula: Operating Earnings = Revenue – Cost of Goods Sold – Selling, General and Administrative Costs – Depreciation and Amortization.
As this formula suggests, operating earnings resemble the metric Ebit (earnings before interest and taxes) — but not Ebitda, which includes depreciation and amortization. For purists, Carlisle noted that operating earnings are calculated from the top of the income statement down, while Ebit works from the bottom to the top of the income statement.
Another important point about operating earnings: It standardizes earnings, making it possible to draw comparisons across companies, industries and sectors.
Now that we have explored the definitions and implications of enterprise value and operating earnings, it’s time to get back to the bigger picture. As noted, the Acquirer’s Multiple is enterprise value divided by operating earnings.
The Acquirer’s Multiple is also a ratio comparable to the price-earnings ratio, and a lower number is better than a higher number. For example, a price-earnings number of 10 is better than a price-earnings ratio of 20, since an investor is paying less to buy a certain amount of earnings. In the same way, an Acquirer’s Multiple of 10 is better than an Acquirer’s Multiple of 20.
Unlike the price-earnings ratio, the Acquirer’s Multiple can be used to compare companies in any industry or sector, and we can use it to compare corporate earnings with bank or bond returns, roughly speaking.
To apply the Acquirer’s Multiple, Carlisle calculated it for every company listed on the stock market. Those with the lowest numbers were the most undervalued and had the lowest Acquirer’s Multiple.
As with Greenblatt, Carlisle developed a method for quantifying the overall attractiveness of a stock, in the latter's case by using the metrics of enterprise value and operating earnings. In the next chapter, Carlisle compares how returns from the Acquirer’s Multiple compare with the Magic Formula.
(This article is one in a series of chapter-by-chapter digests. To read more, and digests of other important investing books, go to this page.)
Disclosure: I do not own shares in any company listed, and do not expect to buy any in the next 72 hours.
