Sumoy

Investment ideas and financial education

some thoughts on equity valuation – high PE companies

Thanks to some remarkable evolutionary tricks, like female menopause, and an increased overall comfort, humans are able to live beyond half a century. Still, enjoying better longevity prospects than most mammals should not prevent us from having our feet on the ground: Eternity is not an inherent condition of human beings…

 

 

Valuing a bond is neat and straightforward: you get paid some more or less defined cash flows on your way, you discount them at a discount rate and, of course, you don’t forget adding you principal at maturity. You get an IRR of your bond valuation, that’s it.

On a long enough period of time, a bond portfolio tended to yield 300bp per annum less than an indexed portfolio of equities. For this meagre additional return, equity holders put themselves at the last place for claiming cash flows from the company. Then, great care has to be taken when valuing the equity part of a firm: here and there companies tend to go bankrupt.

Hidden in the share price there is the embedded assumption that the company will keep on going concern for a (very) long time. In effect, the current share price should be the present value of all future cashflows distributed to shareholders, either in the form of dividends, share buybacks, or cash buildup in the balance sheet. On top of these dividends there is, of course, capital appreciation. The later has mostly to do with the price somebody will be willing to pay in the future for your stocks: this is what impacts the terminal value (somehow an equivalent to the principal of a bond) of a discounted cash flow valuation.

 

Aswath Damodaran is unarguably one of the leading voices in the academic world when valuation comes to scene, in this link you will find one of his lectures:

http://pages.stern.nyu.edu/~adamodar/New_Home_Page/lectures/pe.html

Also from Stern, William Silber and Jessica Wachter give us an even more compact view on equity valuation.  I suggest reading their paper too; the concepts in this second paper are easy to grasp by anybody minimally versed in finance:

http://people.stern.nyu.edu/wsilber/Equity%20Valuation%20Formulas.pdf

Look for the word “forever” in the later or document , or for  “perpetuity” in Damodaran’s. Does not it look a bit bizarre? In Damodaran’s paper, the word “perpetuity” is even accompanied by a reassuring and comforting “simply”: the mathematical expression is simple indeed, yes, but the implications of relying on future cashflows that will occur after my death are not very appealing to me.

 

CAPM aside (more on this later), as a human investor with a limited life expectancy, I do not want to have a terminal value of my DCF calculation so big that I am de facto delaying my purchases in the near future hoping for uncertain dividends that will flow back to my graveyard. High terminal values, most of the time defined as multiples of earnings or Free Cash Flow, may  be needed to get a “buy” signal (=an IRR to equity above a determined hurdle rate) for any stock trading at high (above 20) PE forward multiples[1]

A really high PE for the terminal value (between 20 and 25 is really high) can only be justified if the firm is truly special, enjoys big and sustained ROEs allowing it to pay a dividend and crazily grow the business. To tackle with my discomfort with the need for perpetually high EPS growth, the target market for the company must also be huge, without big threats (in the form of competition, variation of customers’ preferences, or technology changes).

tvalue

Other than this, I am more comfortable with lower fwd PE businesses, where I should be getting a bigger proportion of the value of my investment, normally in the form of dividends or share buybacks, during my lifetime. An unleveraged company with stable earnings trading at 10 times PE might not look glamorous, as you are not buying any nice growth story here, but at least you have some sort of certainty that you might be recovering the bulk of your investment soon. If a growth stock fails to perform as expected, the share price drop is dramatic (look to Research in Motion)… and if we want to take a long-term view on our portfolios, we certainly do not want to rely on bullish growth expectations that might simply not be there.

 

A bit on Capital Asset Pricing Model now. Some valuation practitioners do follow CAPM theory to value their stocks: They amuse themselves in calculating a WACC, which is fed by ethereal measures such as beta, which has to do with previous stock performance of a company with a specific past capital structure compared to an arbitrary index over a capriciously chosen period of time…. Or cost of equity, which is taken as granted from historical performance and interest rate environments.

I would not mind losing my precious time digging into the vaults of the past if, by doing so, I would get infused the ability to come up with superior, outperforming stock ideas. This would be a neat, easy and academic way to tackle the valuation process and eventually outperform the market.  I come myself from an engineering practice where any theory is fully validated, universally, with empirical facts. But, the calculations performed to design, let’s say, a bridge, are neither arbitrary nor capricious, and of course they do reflect reality. They even have embedded a margin of safety component, to tackle unusual events like earthquakes. I counted on infallibility of science when I flew from KL to Phuket a month ago, right? Then, why would I let my financial stability on the hands of a theory that does not work? Reproducibility of findings is at the heart of any empirical science.  The truth is that CAPM is not reproducible; it even fails explaining ex post, so I neglect it.

 

Besides the more academic views above, I like most of the content of the following short papers:

 

Addis

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2138483

The elaboration of this one on terminal PEs is quite good, in the next weeks we will be building on these concepts AND on expected margin volatility). I also like his disdain for PEG ratio. His intention to use a “standard” PE is neat and may be a good tool to gauge the growth embedded in the actual PE.

 

Rappaport and Mauboussin

http://www.expectationsinvesting.com/pdf/earnings.pdf

Delicious reading for the most part of it.

 

and also Wits,  quite compact.

http://www.iassa.co.za/articles/038_sum1993_04.pdf

 

Have fun and sell expensive.


[1] assuming stable earnings, obviously a cyclical stock can display a huge fwd PE (or turn into losses) when its margins shrink… which by the way would be a buy signal as the margins are poised to recover some day

 

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This entry was posted on 24/02/2013 by and tagged .
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