Price-earnings (P/E) multiples are by far the most popular valuation metric on Wall Street. A recent academic study found that 99.1 percent of analyst reports mention some sort of earnings multiple, and less than 13 percent provide any variation of a discounted cash flow model. 2 Still, most investors don’t have a clear sense of what a price-earnings multiple implies about a company’s future financial performance, or how a company’s price-earnings multiple will likely change over time.

The widespread use of relative multiples often compounds the problem. Investors frequently justify their valuation conclusions with apples-to-oranges comparisons of businesses with very different economics. Multiples are ubiquitous but remain, on balance, poorly understood.
In this short piece, we offer an analytical bridge between earnings multiples (and multiples of any kind) and sound economic reasoning. We then discuss the role of relative multiples and finish with a brief discussion of the importance of price-implied expectations in valuation.

Mauboussin: Here are three of the errors we see most often

One of the investment industry’s all-time great thinkers, Marty Leibowitz, covered many of these topics in a series of papers and monographs over the past 20 years (much of this work was in collaboration with Stanley Kogelman). These articles have been compiled for Leibowitz’s new book, Franchise Value: A Modern Approach to Security Analysis (New York: John Wiley & Sons, 2004), which we recommend highly for readers who want to delve into this valuation topic in more detail.

M&M: Melt it into Your Head

One sound and intuitive place to start to understand price-earnings multiples is Merton H. Miller and Franco Modigliani’s seminal 1961 paper, “Dividend Policy, Growth, and the Valuation of Shares”. In the section that demonstrates the theoretical equivalence of various valuation approaches, they show that an investor can express the value of a company in two parts:

Value = steady state value + future value creation

Full PDF here: MM on Valuation

Via: capatcolumbia