The Acquirer's Multiple
The Acquirer's Multiple

The Acquirer's Multiple

Billionaire value-investor Jeremy Grantham knows profits are mean reverting:12 Profit margins are probably the most mean-reverting series in finance, and if profit margins do not mean-revert, then something has gone badly wrong with capitalism. If high profits do not attract competition, there is something wrong with the system and it is not functioning properly. (Location 210)

Investors make the error worse by overpaying for unsustainable growth or profit. They extrapolate out the profit trend and buy. If the stock delivers on the promised growth or profit, it only earns a market return. If it doesn’t, it gets crushed. (Location 233)

High profits are mean reverting, and falling profits dampen the returns to the Magic Formula. The Acquirer’s Multiple buys stocks with mixed profits; some are highly profitable, others break even, and others lose money. It relies on price mean reverting to the value and the businesses improving. (Location 271)

Generals were simply undervalued stocks. Buffett bought the stock at a big discount to its value and sold when the market pushed the price up to the value. (Location 359)

The workouts were stocks on a timetable. They did not wait on market action. Some other force put these stocks on a rocket sled. That force was a corporate action, a board-level decision that delivered a big return of capital or stock buyback, a liquidation, or a sale of the business. (Location 360)

If a general—one of Buffett’s undervalued stocks—stayed undervalued for too long, it might become a control situation. Buffett would simply keep buying until he owned enough to control the company. Dempster started out as just another undervalued stock. When the price didn’t move, Buffett did. (Location 363)

Buffett was always on the lookout for undervalued stocks with a quiet shareholder about to become active. These stocks were at a tipping point. When the big shareholder started doing the things Buffett liked, Buffett knew the stock price would shortly take off. (Location 382)

Buffett preferred to let others do the work, but he would take control if the company kept losing money. He knew the ability to take control put him into a win-win position. If the stock went up, he made money. If it went down, he bought more, fixed it up, and made money:19 (Location 386)

Cowin guessed the liquidation value at $22 million, or $19.46 per share. Berkshire shares traded for $7.50. Buffett said he knew about Berkshire and agreed it was too undervalued. But how would he unlock the value? (Location 413)

Buffett did slowly liquidate Berkshire’s textile business. When he got control, textiles were Berkshire’s only business. Rather than reinvest Berkshire’s earnings in textiles as Seabury would have, Buffett directed them to new businesses. The textile business just wasted away. He finally shut it down in 1985. (Location 451)

Brandt delivered to Buffett a foot-high pile of papers. Buffett read them with relish. He also visited several restaurants in Omaha. He saw they still accepted the card. The fraud hadn’t hurt AmEx’s brand. Buffett guessed AmEx would survive. (Location 492)

Munger was right. A good business bought at the right price was the better investment. There would be no more hostile control situations for Buffett. The returns were higher, but the stocks were too small for his growing bankroll. And the companies didn’t grow. (Location 505)

Buffett hesitated; $30 million was a lot of money. But Munger argued See’s was worth paying up for, so Buffett countered with $25 million. At that price, Buffett and Munger would pay 12.5 times See’s profits and 4 times See’s hard assets. It was a huge leap for an investor who liked to buy stocks at a fraction of hard asset value. (Location 520)

With See’s, Buffett moved beyond Graham’s idea of value investing. Buffett still tried to buy stocks at a big discount from value, but he worked out that value differently. Graham saw the value in the hard assets and tried to buy them at a discount. Buffett saw the hard assets being only as valuable as the business’s ability to profit on them. The higher the profit on assets, the higher the value of the business. (Location 555)

This is the most surprising result of Buffett’s theory of value. Not all growth is good. Only businesses earning profits better than the rate required by the market should grow. Businesses with profits below that rate turn dollars in earnings into cents on the dollar in business value. (Location 586)

The Acquirer’s Multiple compares the total cost of a business to the operating income flowing into the company. It assumes the acquirer can sell assets, pay out the company’s cash, or redirect the business’s cash flows. (Location 730)

The Acquirer’s Multiple is the enterprise value divided by operating earnings. (Location 733)

How would the enterprise value treat these two companies? The enterprise value penalizes the company with debt by adding the debt onto the market cap. It rewards the company with cash by taking away the cash from market cap. The company that owes $5 million in debt has an enterprise value of $15 million ($10 million in market cap + $5 million in debt). The company with $5 million in cash has an enterprise value of $5 million ($10 million market cap – $5 million cash). (Location 778)

Companies with enterprise values of $0 (and less) do exist. A low or negative enterprise value is a good thing to find. It means the company has little debt and lots of cash relative to the market cap. (Location 797)

In his letters to shareholders, Warren Buffett often writes that he tracks “operating earnings before interest and taxes.” At Berkshire, he says his “main focus is to build operating earnings.”41 So what are operating earnings? (Location 807)

Operating Earnings = Revenue - Cost of Goods Sold - Selling, General, and Administrative Costs - Depreciation and Amortization (Location 816)

Operating earnings are very similar to earnings before interest and taxes or EBIT. Many times, the numbers will be identical. But operating earnings differ from EBIT because the operating earnings figure is worked out from the top of the income statement down, and EBIT is worked out from the bottom up. Calculating operating earnings from the top down standardizes the metric, making a comparison across companies, industries, and sectors possible. By excluding special items—income that a company does not expect to recur in future years—ensures that these earnings are related only to operations. (Location 821)

Dresdner Kleinwort found chasing wonderful companies shrinks returns. The gains from using the Acquirer’s Multiple by itself are “sizeable.” The best they said for the Magic Formula was that it would have helped the Acquirer’s Multiple keep up with the market in the dot-com bubble. Undervalued stocks fell behind in the frothy boom from 1997 to 1999. The Dresdner Kleinwort paper concluded, “In general we find that the value strategy is very powerful.” (Location 906)

Mean reversion pushes up the beaten-down prices of undervalued stocks. It pushes up beaten-down businesses, too. (Location 961)

Here is the simple truth: profits move toward the average over time. Only some stocks avoid it, and we don’t know why. Without Buffett’s genius for business analysis, we can’t rely on a high-profit business staying that way. This is why fair companies at wonderful prices beat wonderful companies at fair prices. (Location 1014)

Fair businesses beat the market because investors underestimate the change in the stocks’ price-to-value ratio. (Location 1111)

Buffett knows this, too. That’s why he is careful to buy companies with moats. The Magic Formula does not know this. The Acquirer’s Multiple doesn’t, either. But it pays much less for operating earnings than the Magic Formula, which cause it to beat Magic Formula. The Acquirer’s Multiple is the best of both worlds. It looks for deeply undervalued stocks. And some of them will be compounders given time. (Location 1122)

It is our contention that sizeable profits can be earned by taking large positions in “undervalued” stocks and then attempting to control the destinies of the companies in question by: (Location 1168)

By trying to control the company, Icahn could control his own destiny. He could buy an undervalued stock and single-handedly force its price up to its value. Icahn wouldn’t wait on mean reversion and the market to move up the stock price. He’d use Buffett’s old control situation trick. And he’d do the heavy lifting himself. (Location 1182)

to push (Location 1291)

Few investors had heard of the Acquirer’s Multiple in the early 2000s. This is the age of venture capital, dot coms, and IPOs. Loeb uses the Acquirer’s Multiple the way the corporate raiders used it: to reveal hidden cash, hidden cash flows, hidden traps, and companies carrying huge debt loads. He has used it to dig up Agribrands’s hidden cash hoard the same pile of cash Stiritz is trying to quietly slip into Ralcorp. (Location 1320)