How to Find a Buyout Target

In valuing companies, market capitalization is like the popular kid at school, while the way-underappreciated enterprise value stands aside like a sixth-grade wallflower. That may be all right most of the time, but if you're looking for buyout targets, you really need to care about enterprise values.

Listen up, there'll be a quiz later!
When one company acquires another in a straight-up equity deal, it doesn't just buy the business and all its assets. It also inherits the new addition's debts, capital leases, and convertible financial instruments -- and the cash balance in its bank account. (An asset-purchase transaction is a different animal entirely.)

What enterprise value considers that market cap leaves out is the impact of cash and debt. Lots of cash makes the company cheaper to any prospective buyer, while heavy debt makes it more expensive. Comparing enterprise values with market caps is a nifty shorthand for financial health -- more cash than debt leads to a higher market cap than enterprise value, and vice versa.

It's not a perfect measure, of course. We're relying on cash and debt balances that could be up to three months old. Some industries have lots of long-term financial obligations that act like debt but don't fit neatly into the same categories on a balance sheet. But it's still a quick and easy way to get a handle on what a company is worth when you account for bank balances.

Examples, please
In general, a low enterprise value makes a company an attractive buyout target. For example, Microsoft (Nasdaq: MSFT  ) was playing that game last year in its halfhearted courtship of Yahoo! (Nasdaq: YHOO  ) . A year ago, Yahoo had $2 billion of cash on hand but only $750 million of debt. Think of it as Microsoft trying to buy a $40 billion wallet that already has $1.25 billion in clean, unfolded dollar bills inside. It's a nice discount.

For some companies, the combination of a strong balance sheet and severely depressed market cap can lead to ridiculously low enterprise values. For others, heavy debt can make a mealy mouthful out of a dainty nibble in market-cap terms -- essentially a free-market defense against hostile takeovers. Compare and contrast:

 

Market Cap (millions)

Enterprise Value to Market Cap Ratio

Net cash (millions)

Ameriprise Financial (NYSE: AMP  )

$4,531

0.0

$4,702

Eastman Kodak (NYSE: EK  )

$1,115

0.2

$842

Sun Microsystems (Nasdaq: JAVA  )

$5,831

0.8

$1,381

Pier 1 Imports (NYSE: PIR  )

$55

1.5

($28)

Ford (NYSE: F  )

$6,630

22.1

($139,015)

Data from Capital IQ, a division of Standard & Poor's. As of March 29. Net cash represents total cash and equivalents less total debt outstanding.

Break it down
As you can see above, Ameriprise carries enough net cash to outweigh a heavily punished market cap, and the financial advisor service's enterprise value is negative $170 million. That's not an automatic ticket to Buyout City, as other issues with the company might outweigh the tasty price tag. But I certainly wouldn't be surprised to see a bottom-fishing buyout bid here.

The last two unfortunate souls on my list, on the other hand, have stacked their decks in a very unpleasant way. For instance, a quick buyout might be Pier 1's last hope (since Obi-Wan Kenobi is busy elsewhere), but a debt-ridden balance sheet may keep the suitors at bay.

Told you there'd be a quiz!
To recap what we just learned: The enterprise value is a cousin of the market cap, where cash and debt effects have been baked into the market value of a company. Heavy debt means that corporate buyers may look elsewhere, while plenty of cash is like honey that can attract a buyout from the other side of the forest.

If you see any other obvious honey pots or stink bombs out there, be sure to let us know in our Motley Fool CAPS community or in the comment box below.

Further underpriced Foolishness:

Microsoft is a Motley Fool Inside Value recommendation. Try any of our Foolish newsletters today, free for 30 days.

Fool contributor Anders Bylund holds no position in any of the companies discussed here. A negative price tag? Give me a million of that item! You can check out Anders' holdings or a concise bio if you like, and The Motley Fool is investors writing for investors.


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