Long read: Valuation Multiples – What They Miss, Why They Differ, and the Link to Fundamentals

Valuation multiples such as and specifically the Price to Earning or PE ratio are the most commonly used valuation approach by investors in India as well as globally. In our newsletters, we at Marcellus have highlighted the limitations of multiples as a valuation approach. As this piece shows, Prof Aswath Damodaran makes a further distinction suggesting multiples are a pricing technique and not a valuation technique.

“Pricing a company generally means assigning a multiple to a measure of current or prospective earnings or cash flows, and that multiple can vary based on the market’s mood and the prevailing story about the business. Valuing a company involves estimating the present value of future free cash flows and requires study of the firm’s fundamentals.”

In this research paper, the erudite Michael Mauboussin and his colleague Dan Callahan build on this to articulate the limitations of multiples more clearly.

“The central determinants of corporate value include the level and sustainability of return on invested capital (ROIC), growth, and risk. Companies create value when their investments earn a return in excess of the opportunity cost of capital. Higher growth generates higher value for firms that earn a return above the weighted average cost of capital (WACC). Higher growth leads to lower value for a given negative spread. And growth has no impact on value for a company that earns its cost of capital.

Multiples provide no direct insight into the magnitude of a firm’s investments or whether they will generate a sufficient return. This is the main consideration that multiples miss.”

Furthermore, the paper says, with the evolution of business as companies’ assets shifting from tangible assets such as plant and machinery to intangible assets such as brand and intellectual property, the effectiveness of multiples has further dwindled.

“…the ability of multiples to capture the underlying economics of a business has degraded over time. This is mainly the result of a shift in how companies invest. In prior generations, businesses invested primarily in tangible assets such as factories and machines. These investments were recorded on the balance sheet and expensed on the income statement through depreciation. Today, the majority of investments are in intangible assets, including customer acquisition costs and branding. But companies commonly expense these investments on the income statement as they incur them. Accountants record these investments as selling, general, and administrative (SG&A) and research and development (R&D) expenses. This reduces current earnings.

…the rise of intangibles means that both earnings and invested capital are understated, weakening the signal that earnings and multiples formerly provided.”

Having said that, multiples do serve a purpose if used appropriately. Mauboussin and Callahan go on to help us understand how they can be used judiciously, how to choose the correct multiple based on the context and how understanding the multiples can tell us more about the value drivers of the underlying business.

“…For instance, two companies with the same level and growth rate in earnings per share (EPS) but different ROICs have different warranted P/E multiples.

…In most cases, the multiples of P/E and EV/EBITDA provide a similar signal. But there can be cases where two companies have similar P/Es and dissimilar EV/EBITDA multiples, or dissimilar P/Es and similar EV/EBITDA multiples. These differences are generally attributable to differences in underlying profitability, capital structure, or tax rates.

…Warranted EV/EBITDA multiples are based on ROIC and growth prospects. Baseline EV/EBITDA multiples differ based on capital intensity. The depreciation factor, the ratio of EBITDA to EBIT, provides a useful clue about the appropriate steady-state multiple.”

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Note: The above material is neither investment research, nor financial advice. Marcellus does not seek payment for or business from this publication in any shape or form. The information provided is intended for educational purposes only. Marcellus Investment Managers is regulated by the Securities and Exchange Board of India (SEBI) and is also an FME (Non-Retail) with the International Financial Services Centres Authority (IFSCA) as a provider of Portfolio Management Services. Additionally, Marcellus is also registered with US Securities and Exchange Commission (“US SEC”) as an Investment Advisor.