Price-earnings multiples (PE multiples) are the most commonly used tool for evaluating a stock’s future prospects, but according to Credit Suisse analysts Michael Mauboussin and Dan Callahan, few have a solid grasp on what it means.

“The sloppy use of multiples is almost everywhere you look,” write Mauboussin and Callahan. “PE multiples are widespread in use yet remarkably poorly understood.”

Valuation can be broken down into multiple components

They argue that company valuations are best understood when broken down into two distinct pieces: steady-state value and future value creation. Steady-state value is fairly intuitive, measuring net profits against the cost capital, plus any cash lying around. Future value creation is more complicated. While most investors think in terms of growth, the concept can be misleading because there is a cost of capital. Growing with returns below the cost of capital actually destroy shareholder value.

“Acquisitions are a good example because the acquiring company grows, and in many cases the deal is accretive to earnings per share. That many deals grow the business and earnings yet destroy value is a stark reminder that an acceptable return on incremental investment is paramount,” they write.

Future value creation depends on the spread between return on invested capital and the cost of capital (which can certainly be negative), the size of the investment, and the company’s ability to find investments with a positive spread (competitive advantage period in the equation below).

PE multiple equations breakdown

Steady-state value accounts for 80% of the market’s value

Breaking down the entire market into these two pieces, steady-state value accounts for about 80% of current market values, but that changes over time.

“As of the beginning of 2014, Aswath Damodaran, a professor of finance at New York University’s Stern School of Business, estimated the cost of equity in the United States to be 8 percent. This translates into a steady-state PE multiples of 12.5 times,” write Mauboussin and Callahan.

Steady state PE multiple 0214

percent sp500 from value creation 0214

Understood this way, it also makes sense that most companies’ PE multiples will decline over time as the business matures and the stock price approaches its steady-state value, and while actual stocks are more complex than models, you can see how the decline in PE multiples for mature businesses trends toward what Mauboussin and Callahan call the commodity multiple.

march toward commodity pe 0214

steady state walmart microsoft gannett

“Multiples are not valuation; they are shorthand for the process of valuation,” write Mauboussin and Callahan. Comparing PE multiples without understanding how those multiples break down into component pieces is investing blindly, in their view, and washes out important distinctions between companies by aggregating everything into a single, oversimplified number.