Michael Mauboussin is considered an expert in the field of behavioral finance and has some famous books on the topic including, Think Twice: Harnessing the Power of Counterintuition and More More Than You Know: Finding Financial Wisdom in Unconventional Places.
Michael Mauboussin new report from CS
The price-earnings multiple remains the primary method analysts use to value stocks. 3 Researchers who surveyed equity research reports found that more than 99 percent of the analysts used some sort of multiple and less than 13 percent used any variation of a discounted cash flow model.4 Price-earnings multiples may be a common way to assess the attractiveness of a stock, but most investors fail to have a clear sense of what a particular multiple implies about a company’s future financial performance and don’t understand how multiples change over time.
The sloppy use of multiples is almost everywhere you look. In our opinion, some analysts justify their recommendations with apples-to-oranges comparisons of businesses with different economics, suggest companies should trade at the same multiple as the past without a solid economic justification to do so, and compare price-earnings multiples with growth rates without any mention of the underlying economic returns. Price-earnings multiples are widespread in use yet remarkably poorly understood.
Take as an example two companies, Apple, Inc. (AAPL) and Edison International (EIX), which had the same price-earnings multiple, 12.8, based on year-end 2013 prices and 2014 consensus earnings estimates. Setting aside any perceived mispricing, it stands to reason that the prevailing price-earnings multiple implies radically different outlooks for these two companies. They are in separate sectors (information technology and utilities), with vastly disparate economic returns on capital (AAPL’s CFROI® is 25 percent versus EIX’s 5 percent), substantial variance in the outlook for earnings growth (the expected 5-year earnings per share growth is nearly 50 percent for AAPL and 7 percent for EIX), and very different capital structures (AAPL has net cash while EIX has a healthy amount of debt).
How can two companies so unalike have the same price-earnings multiple? Contemplating how these two stocks arrive at the same multiple from very different directions provides a mental warm-up for the process of carefully considering what comprises a price-earnings multiple. Without a proper appreciation for the factors that determine a multiple, there is no way to apply it intelligently in exercises of relative or absolute valuation.
The value of a financial asset is the present value of future cash flows. Few serious market practitioners would disagree. But many investors shun models that project and discount future cash flows because they deem them too complicated or sensitive to assumptions. Yet these same individuals seem blithely content to rely on multiples.
Here’s the challenge. With discounted cash flow models, the value is sensitive to the inputs. But the assumptions underlying the inputs are explicit. You can compare them to base rates, discuss them, and debate them. With multiples, those assumptions are buried. The assigned multiple becomes a point of persuasion rather than a thoughtful case based on the economic drivers of value.
The goal of this piece is to provide an analytical bridge between price-earnings multiples—really, multiples of any kind—and sound economic reasoning. We’ll start by looking at price-earnings multiples through a classic valuation lens, and will examine the two main components of that model. We’ll finish by discussing the role of multiples in considering price-implied expectations.
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