“There is no such thing as a bad asset, just bad prices.” – Howard Marks

“Crisply put, you want low P/E stocks that are also high quality and growing, with a high degree of certainty about the long-term outlook.” – Joel Tillinghast

According to corporate finance theory, the value of a cash generative asset is equal to the present value of future cash flows discounted back using some appropriate discount rate. Yet, in stock markets valuation is commonly reduced to multiples of some form of business earnings. But, what is in a multiple?

I define multiples as the general consensus of what market participants are willing to pay for a given company’s earnings. I believe John Huber (PM @ Saber Capital) put it best: “Some businesses are worth more, most are worth less.” So, what exactly determines whether a business should trade a higher multiple than another? It should really boil down to three main things: (1) Earning Growth Rates (2) Returns on Capital (3) Discount Rates.

3 Factors

You would expect a company with higher growth prospects to have a richer multiple than another, all else being equal. This is simply because the growing company will produce more cash flows in the future. Growth alone does not justify a higher multiple if the ROIIC is less than the WACC. Growth is wealth destructive if the incremental return on investments are lower than the cost of capital. For this reason, both of these factors are also pivotal in determining an appropriate multiple for a business.

When I speak to my friends about this topic (yes, we do discuss what influences multiples in our free time) an answer that pops up is a multiple sourced from the reciprocal of the cash flow growth rate minus the discount rate. This may sound familiar because that is simply just the Gordon Growth Model. The Gordon Growth Model spits out some multiple – some people forget this. To best illustrate, if given a P/E multiple and told that earnings are equal to distributable cash flow and would grow at 2% into perpetuity with a cost of capital equal to 10%, the multiple on a $1 of earnings earned should be 12.5x (1/(0.10-0.02)). Even when creating valuation models, people are too quick to forget that an exit multiple is still equivalent to some Gordon Growth assumptions.

Market Expectations

In the event all else is equal, lower multiples is a reflection of low market expectations of the ability of the business to create value in the future. If a business has a durable competitive position and is able to earn returns on capital in excess of the cost of capital, the business trading at low multiples will deliver high rates of return. So, what influences market expectations on businesses? There is probably a long list but those should include earnings cyclicality, competitive pressures, cost structures, and of course sentiment. Yet, everyone agrees that no two businesses are truly alike. So how does one reconcile the practice of comparable valuation based on industry?

In my opinion, it makes little sense to decide whether a business is cheap or not relative to peers in the industry unless they share similar economic characteristics. Although companies operate in the same industry, their business economics can be fundamentally different. For example, in semiconductor manufacturing it would be inane to expect TSMC to trade at similar multiples to a GlobalFoundries. One of these businesses has gross margins of 32% versus 55% for the other. One is the only seller of leading edge chips to customers with the largest balance sheets in the world, while the other competes with state funded enterprises and TSMC’s older fabs. As you can see despite operating in exactly the same industry, these two businesses economically are not similar. You can also factor in other risks in the, such as the geopolitical tensions one of the businesses faces versus the other.

An example on the flipside would be Cadence versus Synonpys. The pair sell software (electric design automation tools) to chip designers on a recurring basis. They are the only two companies able to produce software at the leading edge capable for design & verification. They do have some difference in terms of how deep they are ingrained into SD&A (though, following the acquisition of Ansys, this gap may close). For all intents and purposes, these two companies are what you can argue to be comparable. They make cash flow in the same model, same industry, and roughly have the same cost structure – one could even argue the future prospects mirror one another.

Multiples & Investment Returns

“If a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you’ll end up with a fine result.” – Charlie Munger

The above quote from Charlie Munger typifies the importance of ROIC in value creation. Like all good things, some people tend to take it too far. When Munger references an expensive looking price it is not a triple-digit multiple on earnings because of rosy expectations on growth. But instead, companies that trade slight premiums to the market. Not all excellent businesses make good investments, price is a necessary component in stock price returns. In a Bernstein Research Report (42yr database), it was identified that 80%+ of all 10-baggers (90% for tech) were profitable to begin, had a median EBIT margin of 8-9%, and traded modestly below market levels (14-17x P/FE & 2x sales). Though you would’ve made good returns at higher multiples, one of the key drivers noted was multiple expansion along with solid revenue growth and margin improvement. Multiples are not the only function to explain investment returns but they are the only one an investor can control (assuming a small stake in the business). You must pay a multiple that enables your other expectations to be wrong – without this, you risk permanent impairment of capital.

To wrap up, I thought it’d be best to look at both the upside & downside of buying companies that have their multiples rerated. If you were reasonable and bought shares for 12x earnings and the market rerated multiples a decade later to 18x earnings, on the rerate alone you would’ve earned a 4% CAGR over 10 years. I made the simplifying assumption of no growth in that time – once you consider the effects of growth in sales and margin you begin to see how over long periods of time excellent businesses can become excellent investments if the price paid is appropriate. On the other hand, had the business rerated lower to 6x earnings you’d face a headwind of a -6.7% CAGR due to paying too high a multiple.

Multiples can change for all kinds of reasons, sometimes a perennially low one enables share cannibals to reduce share count dramatically (e.g., NVR, Autozone, etc…). To really juice up investment results you’d ideally find companies with durable competitive advantages trading at prices below your assumption of fair value, this protects downside risk should your assessment of the future prospects of the business prove to be incorrect.