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Före detta hedgefondförvaltare, partner och VD på Futuris som utsågs till Årtiondets hedgefond i Europa för perioden 2000-2009
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How to relevantly use (relative) valuation gauges

Topic: Valuation multiples and how you should use them

Summary: the word of the day is relative; relative valuation - both in scope and in time

Nota Bene: This is just a short reflection on valuation multiples and their use. You can emphatically not rely on valuation multiples for investing in stocks - not even the triangulation of a multitude of them.


-Whose E?

That was my superior and mentor speaking back in the year 2000.

I had just suggested a company was cheap or expensive based on its P/E multiple. I had kind of taken for granted that the average of sell side analysts' earnings estimate was the default and final place to go to for calculating P/E ratios. Not just 'kind of'. I did take that for granted.

Silly me.

Whose E? Whose earnings estimate? That question has been my mantra in the stock market ever since. I've just reformulated it as "Trust no one"


Absolute multiples are hard

Start with a valuation multiple you like, e.g., the Price to Earnings Ratio, or P/E.

First you have to decide which E to use, and not least whose E. It could be the most recently published and reviewed quarterly earnings number, or the last 4 quarters, or the last full year. It could even be a projection of next year's earnings (remember though that forecasts are fickle creatures, and often not to be relied upon). By, the way is it your forecast, or some unknown third party's, or an average of some kind of trustworthy group of pundits? Is it based on reported numbers straight up, or adjusted to avoid comparing apples and pears?

That got complicated fast, so lets get back to just assuming we actually have some kind of uncontroversial and relevant earnings number, as well as a resulting P/E multiple.

Let's say your stock has a P/E of 15. Now is 15 cheap or expensive from an absolute perspective?

That's really hard to say, and if you actually could do that at all, investing would almost be easy (except for that annoying business with determining the E, past or projected)

Lesson: The E is very difficult to determine: which period, past or projected, whose projection, is the chosen period representative of the full future lifetime of the company? Likewise, determining whether a certain P/E multiple is attractive or not from an absolute perspective is at least as difficult. If it only were a cash flow multiple, and not just based on the accounting invention of earnings*... Anyway, moving on.

* complicated and obfuscated by varying taxes, deductions, one-offs, goodwill, acquisitions, employee stock options, accounting standards etc.


Why relative valuations matter

The chosen multiple needs to be compared to the history of the company. If it has typically traded between 10 and 15 for a very long time, then 15 is pretty expensive for that particular stock (unless something material has changed in terms of its business)

Another way of gauging whether 15 is high or low is to compare it to other companies in the same industry*. If their average is, e.g., 17, then 15 suddenly looks pretty attractive. Or, if the general market is trading at 20, then 15 might start to look quite cheap.

However, let's not get carried away. The important thing to consider is whether the relative valuation is deviating from its standard. If your company usually trades 5 points below the industry* average, then 15 vs 17 isn't cheap anymore. We would need to see a multiple of 12 to be at all enticed - and that would still just be a meh valuation. Further, if the market premium usually is around 8 points, then that's a second confirmation of a 15 multiple (vs. the market's 20x) not being terribly cheap, but actually some ways on the rich side.

* 'industry' in this context means any single stock or group of companies you consider relevant

Lesson: compare the chosen multiple of your company to the industry's current average, to the market average and to the company's own history. Also remember to take the historical valuation spread vs. the industry and the market into account as well.


There are other relativities to consider such as the point in the cycle

As a final note, industry spreads vs. the market average tend to change during the economic cycle. After a long bull market, like right now, the typical valuation spread might be bigger or smaller than average. Even if the average spread vs the industry is 5 points, it might be just 1 point in aging bull markets. If that's the case 15 vs. 17 might look interesting again and warrant further research.

A word of warning: Do not rely purely on valuation or valuation multiples for short term investments (less than 5 years horizon), in particular not notoriously unreliable ones like the P/E multiple. The least thing you should do is triangulate between several measures, such as Price to Cash Flow, Price to Sales and Price to DCF.

That's of course still not enough, since it might be more instructive to check various technical gauges, such as trends and market breadth, not to mention signals from other asset classes.

And then there is that problem again, with pinpointing a relevant earnings number, cash flow or sales estimate that's representative of the future 25 years. Check out my other articles on investing and valuation under Investments here.


Summary

Fools rush in

P/E-ratios and other valuation multiples are almost useless, but if you are going to use them anyway. make sure you investigate relative ratios in scope and in time before jumping on the "Oh, it's trading at just 10x P/E, it's the cheapest stock in the index" train.

The market doesn't 'weigh' stocks based on their fundamental merits*, it's a beauty competition where you need to figure out what other people are currently thinking, or might soon be thinking - perhaps what they're thinking you're thinking they're thinking, or might come around to think.

* at least not on time scales that are relevant to most mentally healthy individuals.

If you're Swedish, I made a 1-minute video on the topic the other day. Check it out on YouTube here.

If not, I've started making short videos in English as well, e.g., hereherehere and here.


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