Understanding P/E

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P/E remains one of the most used metrics to value stocks. It is very easy to compute. But it’s not always easy to interpret. « Most investors fail to have a clear sense of what a particular multiple implies about a company’s future financial performance and don’t understand how multiples change over time », according to Michael Mauboussin and Dan Callahan in a report published in 2014 by Credit Suisse (this article is mainly based on their note which you can read here).

Some investors invert P/E to look at earnings yield, which might be considered as the prospective earnings return, and potentially one major driver of stock performance over the medium term. The higher the P/E, the lower the prospective return. And this works also with markets as well.

P/E in itself is useless. Same as price or earnings, taken alone.

Key question is how really link this multiple to the fundamentals of a public company and what fundamentals should you look at?

The key point from Mauboussin & Callahan is the following : « With discounted cash flow models, the value is sensitive to the inputs. But the assumptions underlying the inputs are explicit. (…) With multiples, those assumptions are buried. The assigned multiple becomes a point of persuation rather than a thoughtful case based on the economic drivers of value. »

First of, the value of the firm can be estimated as the sum of the steady-state value and the future value creation. This comes from the work of Merton Miller and Franco Modigliani.

Steady-state value is defined as:

Source: Mauboussin, Callahan (2014)

« A company arrives at its steady-state value when its incremental investment earn the cost of capital. » At this level, the appropriate P/E multiple is the inverse of the cost of equity (1/cost of equity). If you assume that the cost of equity of firms listed in the US is 10%, it means those companies should trade at a P/E multiple of 10x.

Cost of equity is derived via the CAPM model (=risk-free rate + beta * risk premium) – you can find a discussion of cost of equity and cost of capital on A. Damodaran’s website.

Future value creation is estimated with the following formula:

Source: Mauboussin, Callahan (2014)

The future value creation formula relies on 3 key drivers: the spread on the return on incremental invested capital and cost of capital; The magnitude of the investment (); How long a company can find investments with a positive spread.

Per Mauboussin and Callahan, « the first two drivers dictates the rate of growth ». Most important observation from them : « whether growth is virtuous depends on the firm’s incremental economic returns. A company can growth its earnings per share without creating shareholder value. »

The bridge with P/E multiple is that based on the above formula, you can disaggregate a P/E multiple into a « commodity component » and a « franchise component ».

The importance of value creation drivers, i.e. investments returning more than cost of capital, is central. If the return is equal to the cost of capital, the « franchise component » is worth zero.

The formula allows to integrate the growth factor and help investors think about the ability of companies when it comes to capital allocation.

It makes sense to pay higher multiple for higher returning companies but also for companies that have a good ability in allocating capital to high returning investments.

There are 3 lessons from their demonstration :

  1. A company earnings its cost of capital trades at the commodity price to earnings multiple (i.e. the inverse of its cost of equity).
  2. If a company generates returns in excess of its cost of capital, a faster growth translates into higher P/E multiple.
  3. Companies earning below the cost of capital will destroy shareholder value. That’s most apparent when companies overpay in acquisitions.

« The final component of future value creation is how long a company can find attractive investment opportunities. M&M referred to this as simply ‘T’, but it it also known as ‘value growh duration’, ‘competitive advantage period’, and ‘fade’. »

Some researchers have shown that the sustainability of the competitive advantage varies among industries, and lasts about 8 years in average, from « 5 years for very competitive industries to 15 years for industries that are more stable. »

There are other limits in using P/E multiples, especially when looking at historical series or when comparing companies within the same sector. Every time, the garde-fou is to look at fundamental drivers and make sure they are consistent over time.

As with many valuation models, each technique has its pros and cons. Investors should always be mindful that those models rely on several inputs and on subjectivity.

No model tells the truth. They just give an approximate estimate of what the future might be. But there is always an error factor. This should lead to humility in the difficult task of assessing the value of any asset.

Nota

Mauboussin and Callahan remind us that P/E multiple are driven by a number of factors that investors should always bear in mind: interest rates, inflation expectations, the equity risk premium (which reflects the investor sentiment), the business cycle, tax rates, the quality of earnings, growth prospects and investment opportunities.

By no means are P/E multiples a rational metrics of firm valuation. They depend on so many factors that they are actually quite complex to analyze.

Investors should always use them with care and caution.