“Private equity acquisition activity could well reach unprecedented levels in 2007, withy Australian equity markets providing attractive opportunities,” writes John Allerton, a bean counter from Ernst and Young. This is interesting inasmuch as the private equiteers are now advancing the argument that capitalism, or capital markets, have reached a new stage: companies run inefficiently can effectively have their management involuntarily outsourced through private equity takeovers.
Allerton explains, “Private equity has previously profited from arbitrate strategies, buying assets at lower multiples and selling at higher multiples. But the industry has shifted, driving value through growth strategies and effective operational management skills.”
“Some deals are so competitively priced in offshore markets that private equity funds are acquiring assets on higher multiples and on selling at lower multiples-making money solely from improving the financial performance of the underlying business.”
Typically, one does not make money as an investor by buying high and selling low. But the keyword here is ‘multiples.’ There are two factors in a price to earnings ratio. The first is what investors are willing to pay for tomorrow’s earnings. The second is what those earnings are.
Let’s say a poor management team produces earnings per share of $1.50 and the stock trades at price to earnings multiple of 10. After all, with slow revenue growth, investors are not willing to pay a premium for future earnings. In that scenario, you get a share price of $15. Now let’s say a new team of pirate equiteering wizards steps in and doubles the earnings per share from $1.50 to $3.00 through hidden synergies and better management. The price-to-earnings multiple could actually decline by half, from ten to five, and you’d still have the same share price.
In other words, a $15 stock with earnings per share of $3.00 trading at five times earnings has the exact same market value as it does when producing only $1.50 in earnings, but trading at 10 times per share, namely $15.
The difference between the two is that one appear overpriced and one appears fully priced, even though the multiples are the same. What counts are the earnings, and the ability of the management to grow them. Why would a private equity firm be better at growing a firm’s earnings than a management team that knows what it’s doing? It wouldn’t…unless the management team didn’t know what it was doing.