Broyhill Asset Management presentation titled, “Don’t Confuse Cheap With Value”

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Key Takeaways

  • 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?

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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?

Broyhill Asset Management - Cheap Value

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?

Broyhill Asset Management - Cheap Value

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.

Broyhill Asset Management - Cheap Value

Let’s try another one. I’m going to give you a statistic, and you tell me which business is the better value.

  • PE
  • Dividend
  • Growth

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.

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