Broyhill Asset Management presentation titled, “Don’t Confuse Cheap With Value”
- Multiples are shortcuts; not valuation
- Growth is not value; without adequate returns
- Smoking is dangerous; don’t confuse cheap with value
- Moats matter; don’t confuse activity with accomplishment
What does a multiple mean?
Cheap vs Value
The market's price-to-earnings multiple has historically averaged around 16x normalized earnings
But what does a PIE ratio actually tell us?
The market’s long-term average P/E multiple tells us that if you buy the market at an average price, you should expect long-term average returns. If you buy the market at a lower price, you’ve historically earned higher than average returns. The reverse, of course, is also true.This is common sense.
With a long enough time horizon, we know this works if you are buying “the market”.. but what about buying individual businesses?
How do we know the “right” price?
Let’s play a little game. We have three businesses here. An investment bank. A technology company. And a mature biotech firm.
They all trade around the same multiple of earnings. They have very different economics. What does the P/E multiple tell you? Which of these businesses is cheap? Which is expensive?
The point is, we need more information. A low P/E isn’t always cheap. And as we’ll see in a moment, a high P/E isn’t always expensive.
Let’s try another one. I’m going to give you a statistic, and you tell me which business is the better value.
OK. What are we missing? What information do we need to assess the value of these businesses.
Would this change your opinion?
It should. Company A should trade at about 7x all else being equal. Company B - about 16x. Why? Good question. Let’s have a look.
Common yardsticks tell you little about valuation. But they make great shortcuts for lazy investors and good material for talking heads. But as we’ve seen, P/E’s tell us little about value. In order to truly understand what something is worth, we need to understand two variables. Cash in. Cash out. That’s it.
Most investors have a tendency to focus on the “cash out” - this is the fun part. It’s what managements boast about in earnings releases. But how often have you seen a management team tell you about the massive investment required to generate that cash. The “cash in” is just as important!
Here’s a classic example:
Berkshire bought See’s Candy for $25 million in 1972. Its sales were $30 million. Pre-tax earnings were less than $5 million. The capital required to run the business at the time was $8 million.
From 1972 to 2007 See’s sales grew to $383 million. Pre-tax profits grew to $82 million. And the business only required an additional $32 million in capital. That additional capital generated $1.35 billion in cumulative pre-tax earnings.
See the full slides below.