We talk a lot about multiples in investing.
I find they can often be more misleading than helpful for the best businesses.
Really just thinking on paper here, so keen to hear from others - what are some issues with or benefits you see from using Multiples?
Below is a framework I use to try and get something useful out of them or at least not get thrown by them.
Multiples are not valuations, multiples are more like pricing.
Multiples are invariably price (or market cap) over some revenue, earnings or cashflow number.
It’s a stock vs a flow. It’s like comparing a P&L number (12 months flow) to a Balance Sheet number (stock).
That said, they are widely used because they are so simple to calculate and easy to (mis)understand.
When using Multiples, here are some things I try to consider.
Firstly - All valuations are a derivative / simplification of a DCF which is the only theoretically sound methodology for estimating the intrinsic value of a cash generating asset / business.
The simplification is usually that assumptions being made are implicit, whereas in a DCF they are explicit (you need to choose the inputs you’re going to use).
DCF is also independent of share price.
Secondly – Make sure the multiple is logically constructed. For example Price to Earnings is, Price to Sales is not.
Third - Make sure the multiple being used (earnings, etc) is a valid representation of operational performance or Free Cash Flow. For example, Adjusted EBITDA can be used in a multiple but it might be more misleading than useful. That would depend on what is included in D&A, if they have a lot of debt, what’s being Adjusted, etc.
Fourth – Consider if this is a trailing or forward multiple. All the audited performance is in the past but all of your risks and opportunities are in the unknowable future. Trailing might reduce relevance, forward might reduce reliability.
Fifth – be careful what implication you take from a given multiple. If a multiple is higher for a business today than it was previously, this suggests the market outlook is better for this business. What’s your outlook?
Sixth – PE is probably the most useful (Price to FCFE too), especially when you invert it to get an earnings yield. For this to be reliable, you need to know how reliable the earnings are. They might be less reliable if aggressive or conservative accounting has been used, abnormal items have been included or excluded if they’re not so abnormal, if the business is over or under earning at present, etc.
Not that this matters to us as bottom up stock pickers but for those interested below are the market assumptions from Fidelity.
Profit margins are clearly seen to be reducing from the current elevate levels. Interesting that they have multiple expansion (valuation) everywhere but the US - highlighting how the US is seen as more expensive than other markets.
Finally on the subject can see the recent market weakness is all multiple compression. Where yet to see a hit to earnings from any economic slowdown in the recent earnings season.
