Valuation multiples compare company value to a measure of profit. The most common multiple is the price to earnings (P/E), where the price per share is compared to earnings (net profit) per share. Intuitively, this makes sense as a way to estimate valuation: when buying a share, we are acquiring a claim on a portion of a firm’s profits, and higher profit per unit invested implies better value, all else equal.
The simplicity of multiples is what attracts many investors. However, this simplicity masks a range of underlying assumptions. A business is valuable because of the future cash flows it can generate for its owners. For simplicity, we can think of these cash flows as dividends. The value of a business is therefore the sum of cash flows received today and those expected in the future (adjusted to reflect today’s value).
If future dividends are expected to grow, a higher growth rate increases value, all else equal. However, growth requires investment, and the return generated on that investment is critical (i.e. the return on invested capital). Higher cash generation per unit of reinvestment is preferable. Finally, cash today is worth more than cash in the future, so future cash flows must be discounted using an appropriate discount rate.
It should therefore be clear that the price attributed to one unit of profit varies based on several factors. Many investors rely on historical average multiples or peer comparisons. However, without considering differences in growth, returns on investment, and discount rates, this approach can lead to errors. We therefore agree with Morgan Stanley’s Michael Mauboussin that the use of valuation multiples must be earned.
