Identifying Takeover Targets

The most common measure of a company's size is market capitalization, which is the value of all outstanding shares of the company's common stock. However, when evaluating a company's worth, the experts say investors should look at a similar measure: enterprise value. In addition to common stock, enterprise value considers debt, minority interest, preferred stock, and excess cash.

Enterprise Value Formula

The formula used to calculate enterprise value is shown below:

Enterprise Value = Market Cap. + Preferred Stock + Debt - Excess Cash

Where:

• Market Capitalization = Shares of Stock Outstanding x Current Stock Price

• Preferred Stock = Value of Preferred Stock (as found on the balance sheet)

• Debt = Long Term + Short Term Debt (all debt from the balance sheet)

• Excess Cash = Total Cash - (Current Liabilities - Current Assets)

The enterprise value formula is based on the idea that the worth of a company is the sum of all outstanding obligations (stocks, bonds, debt); minus the cash the acquired company has on hand. This last point is an important one. When one company buys another, it can use the cash held by the target company to help offset the cost of buying that same company.

Earnings Before Interest, Taxes, Depreciation and Amortization is a good measure of a company's ability to service its debt. It is also a very good way to measure the profitability of a company, because it eliminates the effects of accounting and financing decisions.

Since EBITDA "normalizes" profits, it allows the investor to compare the earnings capability of a company without worrying about its capital structure, or financial leverage. In the same way, this makes EBITDA the ideal measure to standardize the value of a company.

Identifying potential takeover candidates now becomes a relatively simple exercise for the investor, market analyst, or strategist. The formula used to calculate the attractiveness of a company becomes:

= Enterprise Value / EBITDA

Looking at the takeover target formula above, it is evident why it is effective at valuing companies. The formula takes the worth of the company and divides it by its ability to generate profits. A large company, in terms of enterprise value, should be able to generate more profits, while a smaller company would be expected to generate proportionately fewer profits.

Since it's desirable to acquire a company that generates larger profits relative to its size, a takeover target will have a relatively small Enterprise Value / EBITDA ratio. In other words, the smaller the ratio, the more attractive the potential target.

This first group of companies was pulled from a larger set of 50 companies that were screened for their high intrinsic value. These companies should be considered solid financial performers, pulled from a large universe of high-quality stocks. This first group will serve as a benchmark when making comparisons later.

We've taken the list of 50 companies and sorted them based on their EV / EBITDA ratio. The stocks at the top of the list appear below:

Note: All values as of April 2009.

Our top ranked company, Ensco seems like a bargain and a prime candidate for a takeover. In fact, during the month of March 2009, Ensco was named on several occasions, and by several different sources, as a stock that was undervalued.

The next group of stocks we're going to evaluate is the infamous Dogs of the Dow in 2009. These are member companies of the Dow Jones Industrials with the highest dividend yields. The entire population of these ten blue chip stocks appears below in order of their takeover potential.

The interesting observation to note in this group is the fact that even though all these prestigious large cap stocks are undervalued relative to their peers, the takeover target values for all these stocks are higher than the benchmark group.

In this last example, we're going to look at a couple of attempted high-profile takeover targets of 2008 and 2009, to see just how attractive these companies were to their suitors.

Back in February 2008, Microsoft attempted to negotiate a deal that would result in the acquisition of Yahoo. At that time, Yahoo's stock price had fallen to around $20 per share, and Microsoft's offer translated into nearly $30 per share. This represented a 50% premium to shareholders.

In April 2009, Yahoo's stock price had fallen to around $12 per share. Microsoft was still interested in Yahoo, even though the Enterprise Value / EBITDA ratio was 11.448, which is a very unattractive number.I

BM pursued Sun Microsystems in another failed takeover attempt in early 2009. At that time, the takeover formula indicated an Enterprise Value / EBITDA ratio for Sun was 4.177, which makes it quite a bit more attractive than the Yahoo deal from an economic standpoint. Perhaps this is why Oracle pursued Sun too.

That brings up one final point worth discussing. Takeovers are not all about economics. Is it possible to identify a good candidate by examining a company's financial statements? Absolutely; the formula is a good screening tool for companies and investors - anyone looking to buy a company.

But wise investors should never underestimate the cultural or strategic value the deal might bring to the table. Furthermore, never misjudge the egos that will be involved in these high-profile takeovers. Powerful leaders will often look at potential targets and convince themselves they can turn unprofitable companies around with their sophisticated management techniques and superior leadership skills.