The stock market aggregate valuation is usually assessed through the so-called valuation multiples, as well as individual stocks, which are often valued on the base of the relative valuation methodology. However, in the current bull market, more and more people have been disregarding multiples as a tool to estimate the objective price of a stock. The reason for this, I will argue, is that the relative valuation approach might have two problems: the first, inspired by this Twitter thread by @financialsigma, is that we might not be actually valuing when using multiples, and the second is that multiples might not be a useful tool to financial analysis.
Are we really valuing when we use multiples?
Whenever we estimate the objective price of an asset based on the market value of a similar asset we are not valuing, we are just analysing how much the market is willing to pay for similar companies (peers multiples). This idea, which I agree with, brings up one of Damodaran’s brightest statements, tweeted by Emérito Quintana: “that’s not valuation, that’s pricing”. In this short video at PwC, Damodaran shows why pricing is not the same as valuing: “We know what drives value. It is cash flows, growth and risk”; whereas “when you think about price, you have to think about the fundamental, but you have to think about the rest of the market as well”. In fact, he says that “95% of all valuations out there are really pricing” because they are based on multiples instead of intrinsic valuation.
So, if relative valuation is not actually valuation, why is it widely used? Ceteris paribus, a low multiple implies a higher return, so investors tend to compare the trading multiples of companies in the same industry, assuming that they are identical to determine which one is relatively cheaper. Alternatively, if two companies are trading at the same multiple but one is better in terms of risk and expected growth, this one will be deemed a better investment than the other. Therefore, although multiples are just a way of pricing an asset in terms of the market price of another instead of a valuation instrument, they seem to be a useful tool in financial analysis. Yet, I will argue against this statement in the next section.
Are multiples useful?
The essence of relative valuation consists of comparing companies that have similar characteristics (same industry, same geography, size, level of maturity, etc). However, it is well known that there are no identical stocks, so the objective prices arising from multiples must be taken as a proxy, never as an accurate estimation of the expected price.
Besides the above limitation, which does not fully incapacitate multiples as a financial analysis technique, they have technical problems which might limit further the value of relative valuation as a tool for financial analysis. Typical multiples are P/E, which considers net profit, or EV/EBIT, which considers net operating profit (i.e. before depreciation and amortisation). Both, net profit and operating profit are just accounting indicators but could have no sense from a financial perspective. Let´s see two potential limitations arising from this fact and two extra ones:
- Capex and working capital investment: each company has different capital requirements in order to continue with its recurring operations (other than growth) and, although there are clear patterns across industries, there is a lot of divergence within each sector since companies are rarely similar. To solve this problem, it is typically assumed that in the long term, capex equals depreciation and amortisation, which make very little sense in many cases. Additionally, working capital management might be a key element in the long-term success of a company and it varies widely across companies depending on the management, as we will see later. No multiple, except FCF-related ones, consider these elements, so a lot of information is skipped by using them.
- Investment through P&L: in the current economy, led by the so-called technological companies such as Amazon or Netflix traditional investments in capital goods, factories and other tangible assets are being replaced by other investments in enhancing the value of the brand or acquiring clients. Marketing, as an example, could be considered an investment, since it improves the brand perception of the society and allows the company to grow at higher rates. However, from an accounting perspective, it is an operating expense included in the income statement, which prevents the company to increase the value of its assets and makes both net and operating profit lower than if marketing was considered a capital expenditure.
- Capital allocation: one of the key drivers of stock returns comes from the quality of the management, which materializes in the capital allocation strategy. Some stocks such as Berkshire Hathaway have yielded above-the-average returns as a result of the outstanding allocating skills of Buffett and Munger. Accounting measures ignore these abilities so by using multiples we take the risk of missing companies managed by outstanding people.
- Going forward approach vs historical: while accounting gives a historical view of the company, all its value comes from its future perspectives. Therefore, looking at historical figures to estimate value, although in many cases can be a good approach, might be misleading. What is the value of a money-losing company or a firm that is in the middle of a restructuration? An orthodox application of relative valuation would give a zero value (or even negative!!!). As a consequence, a pure quantitative relative valuation will ignore these companies, which in some cases might become wonderful investments.
Valuation is neither a science nor an art. As Damodaran says, valuation is a craft where neither the laws of pure sciences apply nor the innate abilities of an artist are required. A good valuation is always a combination of narratives and numbers and both, intuition and methodology, are always necessary.
Multiples could be said to be the most scientific (i.e. quantitative) part of valuation and, if applied blindly, might lead to investment errors. Therefore, although I do not reject them as an intuitive heuristic to approach the value of a firm, I would definitely turn multiples down as a standalone and unique tool for valuation.
- What Does an EV/EBITDA Multiple Mean?, by Mauboussin
- What Does a Price-Earnings Multiple Mean? By Mauboussin and Callahan