About 6 months ago I came to the realization that, I do not know what makes a stock ‘undervalued’ nor do I believe most people do either. If there was one fool proof method then no other methods would exist! Instead, I decided to make the conscious choice to apply a different method every 6 or 7 methods and adjust accordingly. Well as fate would have it about 2 or 3 weeks before it was about time to take a left turn on the valuation method I was using, I was listening to a podcast that I absolutely love called the investor’s podcast. On this particular episode was Tobias Carlisle, a regular guest and active asset manager was discussing his system known as Acquirer’s Multiple.
During the episode Toby kept referring to his system and a relatively new (and straight forward) book which goes over it. Since I was traveling in the near future (I am writing this post from a B&B in Doolin, Ireland while The Wife sleeps) I knew I could finish up the relatively short book between the flight and some down time. If you consider yourself a value investor I would 100% read it, however, I am going to discuss the basics and how I plan on applying his particular formula.
The Goal of the Acquirer’s Multiple
Toby puts forth his goal pretty succinctly, which is to find,
Fair companies at wonderful prices…in this test we buy the most undervalued stocks with no regard for profitibility…
The Methodology Behind the Acquirer’s Multiple
…and now we have to define the parts of the equation.
What is the Enterprise Value? How is Enterprise Value Calculated?
…(EV) can be thought of as the theoretical takeover price if a company were to be bought. EV differs significantly from simple market capitalization in several ways, and many consider it to be a more accurate representation of a firm’s value. The value of a firm’s debt, for example, would need to be paid off by the buyer when taking over a company, thus, enterprise value provides a much more accurate takeover valuation because it includes debt in its value calculation.
Why doesn’t market capitalization properly represent a firm’s value? It leaves a lot of important factors out, such as a company’s debt on the one hand and its cash reserves on the other. Enterprise value is basically a modification of market cap, as it incorporates debt and cash for determining a company’s valuation.
To calculate Enterprise Value you take market capitalization plus any outstanding debt, minority interests and preferred shares minus any cash. The idea is to get the true cost of a company taking over the business. For example, if I were to buy company ABC and it has a market capitalization of $100 and debt of $50 with cash of $25 the enterprise value would be $100+$50 (b/c it has to be paid off) – $25 (b/c cash isn’t the enterprise) = $125.
What are Operating Earnings? How are Operating Earnings Calculated?
Operating Earnings are defined as the,
profit earned after subtracting from revenues those expenses that are directly associated with operating the business, such as the cost of goods sold, general and administration, selling and marketing, research and development, depreciation and other operating costs. Operating earnings are an important measure of profitability, and since this metric excludes non-operating expenses such as interest and taxes, it enables an assessment of the company’s core business profitability.
Operating earnings is interchangeable with operating income, operating profit and earnings before interest expense and taxes (EBIT).
The same investopedia article goes into some great detail
BREAKING DOWN ‘Operating Earnings’
Operating earnings lie at the heart of internal and external analysis of a company’s profitability. The individual components of operating costs can be measured relative to total operating costs or total revenues to assist management in running a company. Many variants of metrics stemming from operating earnings can also be used to compare a given company’s profitability with those of its industry peers.
We are basically figuring out what the company actually earns.
Screening for Low Scoring A.M. Stocks
Toby provides a fantastic service at his site, however at $50/month I decided that right now was not a great time to invest in it. I am only investing $500 to $1,000 a month into my dividend growth investment portfolio so we would be looking at a cost of .5 to 1% of my monthly purchase. I think there is value in Toby’s service, but right now I am comfortable doing a little extra leg work given the amount I am investing.
I found a service called Screener.Co for half the cost which basically created the screen for me and all I have to do is download the Excel File. If you know of a free screener please let me know!
Applying My Twist on the Acquirer’s Multiple
I have not wavered on my desire to create a future, sustainable dividend growth portfolio. Notwithstanding, I am well aware of the importance of buying the underlying company at the ‘right price’ which is the reason that I am going to run a screen on the above referenced site and then cross reference it with stocks that have increased their dividend for at least 20 years. Once I have a list to check out I’ll then look for those with a payout ratio of less than 60% and closer to their 52 week low (for mean reversion purposes that Toby also discusses).