Valuation with P/E Ratios: Part 1 of 2 Simplifying the Math to Focus on the Business
Common valuation processes and formulas can be overwhelmed by esoteric processes and mindless DCF bookkeeping. Can we apply the lessons of Warren Buffett, Charlie Munger and others and spend less time on mechanics and adjustments to adjustments and more time on what matters most: trying to understand a business and its drivers of growth?
“Investors should be skeptical of history-based models. Constructed by a nerdy-sounding priesthood using esoteric terms such as beta, gamma, sigma and the like, these models tend to look impressive. Too often, though, investors forget to examine the assumptions behind the models. Beware of [#cashflowbros] bearing formulas. ” -Warren Buffett
This post covers how thoughtful valuation, using P/E ratios, can enable us to reduce the time spent on mechanics and increase the time spent trying to understand each business, how it operates, how it generate revenue and incurs expenses... the goal is that through this thoughtful understanding we can best consider company-specific motivations for the future.
The Evolving Story: …the answer lies in analyzing not the effects and outputs of a business, but, digging down to the underlying reality of the company, the engine of its success. One must see an investment not as a static balance sheet, but as an evolving compounding machine. -Nick Sleep’s Nomad Investment Fund Shareholder Letters (April 13, 2021)
Why Do We Value Companies?
Valuation itself is an attempt to estimate what a company should be worth a thoughtful consideration of how we believe the company will perform in the future. This is our estimate of a company’s intrinsic value. Naturally, our estimate of intrinsic value can differ from the company’s current market value. The thoughtful consideration of how the business will perform in the future is essential for potential investors, but is valuable to other stakeholders as well: employees, lenders, major customers or suppliers, etc.
The Intuition of Valuation
In valuation, we generally offer that an investment is worth the present value of its future cash flows. Common processes work well when we have contractual (i.e., easy to predict) cash flows, such as with a bond or a debt arrangement. In this case, we determine the amount and timing of these cash flows and then incorporate a discount rate that reflects the time value of money and the risk we face with the investment.
When investing in a company, we become shareholders and, in so doing, invest in the company’s equity. Companies earn money and create value for their investors, but unlike bonds or debt arrangements, companies do not offer strictly determined contractual cash flows to their shareholders.
Companies create cash flows by running their business. Specifically, the drivers of cash are the company’s ability to generate and grow Revenue (revenue is the value created for the customer) and maintain or grow margins over time. Profits result from creating more value for the customer (revenue) than the costs (or Expenses) incurred by the company. When we estimate a company’s future revenues and expenses, we are effectively estimating its future profits or earnings.
Combined, a company's revenues (inflows) and expenses (outflows) translate to the net cash flows?it generates from its business.
A Quick Overview of the Choices We Could Make:
If our estimate of value is different from the company’s current value, we may have overlooked something or made a mistake, we may have made a series of mistakes or we could be right… we may have identified a situation where the company’s current price is different from thoughtful expectations of value.
If our estimate of the company’s intrinsic value is meaningfully higher than the current value, we may want to consider buying the stock or going long in the company. The hope here is that the market, which represents the collective opinions of everyone, will transition to our view and thus the company’s value will move towards the intrinsic value we estimated.
If our estimate of the company’s intrinsic value is meaningfully lower than the current value, we absolutely may want to consider passing on or not buying the stock. If we were a professional investor, we may want to consider shorting the stock, but this post does not advise such a choice for individual investors.[i]
Methods of Valuation
One way we can estimate value is by constructing a valuation model. This can be a Discounted Cash Flows Model (i.e., a DCF). Here we estimate future revenues and expenses across time and then translate these to cash flows. Generally, this is done by forecasting Income Statements and Balance Sheets and then calculating the cash flows the result from our estimates. Here, our estimates can include numerous years of annual forecasts as well as a terminal period, which is when we expect the company’s performance to stabilize.[ii] With these types of models, we also have to estimate a discount rate to reflect the risk that the company faces and use the discount rate to determine the present value of the cash flows from our model.
Unfortunately, these types of models may require considerable time with various mechanical or bookkeeping adjustments. The more time we spend on adjustments and mechanics, the less time we have for understanding the business itself. The following is the discounted cash flow (DCF) process created by UBS. This is the main formula presented in a 32-page deck. Their approach is similar to the formulas we see in textbooks, slide decks, LinkedIn content and other sources. Quite fascinatingly, this approach skips any inclusion on revenues and expenses, yet it emphasizes a series of involved adjustments for specific items.
While DCFs can be simplified and streamlined with a focus on the company’s core business via revenues and expenses and de-emphasizing the various bookkeeping adjustments (see the simplified 9 page valuation slide deck linked here or a single page overall guide in excel here ) they are still quite involved.
Valuation Via Multiples
Another way to estimate value is by using multiples or relative valuation: Here, we assume that a company should trade as a multiple of a representative payout (such as 20x its earnings, read as twenty times). Similarly, with relative valuation, we assume that truly similar companies should trade at the same relative value. That is, the value of the set of companies would be relative to a representative payout. The argument here is that the market should give the same relative value to companies that are truly similar?(in terms of growth potential, margins, risks, etc.).
Multiples: A Broad, Conceptual and Human Take [vii]
Before going any further, let’s add a broad and conceptual point about multiples.
Like most discussions on valuation and related areas, common approaches may sound sophisticated and inaccessible. However, most of this material can be approached or discussed with accessible language: The numerator is the value or the output we expect. The denominator is the flow or what we put in on a recurring basis. Stated differently, a multiple expresses this core idea:
The output or value we expect to get out of something is a function of what we put in on a recurring basis.
This core idea is not unique to valuation and should work for many human applications: health, fitness, relationships, learning, hobbies, skills, etc.
Price to Earnings Ratio: The Price to Earnings Ratio is one form of relative valuation, which we will cover extensively here. Another is Price to Sales. Another is Enterprise Value to Net Operating Profit After Taxes (NOPAT).
Let’s do a quick example:
First, let’s assume we have two companies, Company A and Company B, with identical characteristics, except their size.
Company A generates $10 of Earnings (Revenue of $100 and Expenses of $90 = Earnings of $10). Let’s assume here that companies like A should be priced at 20x their earnings. Accordingly, the value of Company A is 20 x $10 = $200.
Assume Company B is the same, except that it is smaller: Company B generates $5 of Earnings (Revenue of $50 and Expenses of $45 = Earnings of $5). If companies like A and B should be priced at 20x their earnings, we could estimate that the value of Company B should be 20 x $5 = $100.
Assume Company A is correctly priced and Company B was truly similar to A in terms of growth, margins, risk, etc. Now if Company B.v1 currently only has a P/E ratio of 12x, it would only be valued at 12 x $5 = $60. In this case, we could argue that Company B is undervalued and we could buy it if we believed the market would correctly value Company B over time. If the market eventually gave Company B a valuation of 20x earnings as expected, it would increase to $100 and we would get a return 67%.
Conversely, if Company B currently has a P/E ratio of 30x, it would be valued at 30 x $5 = $150. In this case, we could argue that Company B.v2 is overvalued and we would not buy it if we believed the market would correctly value it over time. Our reason would be that although it is currently valued at $150, we expect the value to drop to $100.
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That’s just math. Multiplication.
Moreover, our assumption that these two companies are identical is a major one. In reality, there could be many differences between these two companies. These differences include what can happen in the future with respect to the companies’ growth potential, margins and risks. The value we can add as humans is combining our thoughts on the what, why and how of these differences (which is not easy) with the simplicity of the math of P/E ratios. We’ll cover how to apply this to real companies in a moment, but first let’s elaborate on our introductory examples:
Here let’s introduce Company C. Company C has a P/E ratio of 30x and $5 of earnings and is currently valued at $150. However, now let’s also assume that Company C has better growth prospects that Companies A and B. Specifically, we expect Company C to grow its Revenue to $100 and maintain its margins, letting earnings grow to $10 (holding all else equal for C as well as holding everything equal for A and B). In this case, we could argue that Company C is not only not overvalued, but actually undervalued. We could buy Company C if we believed the market would correctly value Company C’s over time. Here we would get a return of ~33%.
Importantly, it could be worth investing in Company C even though it initially had a higher P/E ratio (30x) than both A and B (20x). The reason for this is that Company C is not identical, rather Company C has an attractive growth opportunity that Companies A and B do not have.
For completeness, let’s introduce Company D. Company D also has a P/E ratio of 10x and $5 of earnings and is currently valued at $50. At a first glance it seems undervalued; however, now let’s also assume that Company D expects a decline in margins that the other companies will not face. Specifically, we expect Company D to shrink its margins so that its earnings drop from $5 to $2 (holding all else equal for D as well as holding everything equal for A and B). In this case, we could argue that Company D is not only not undervalued, but actually overvalued. Here, even though it has the lowest P/E ratio, we would not buy Company D if we believed the market would correctly value it over time. Our reason would be that although Company D is currently valued at $50 with a P/E of only 10x, we expect the value to drop to at most 20 x $2 or $40 (Company D would be worth even less with a multiple lower than 20x, such as 10x as it would only be worth $20).
Again, it could be worth passing on Company D even though it initially had a lower P/E ratio (10x) than both A and B (20x). The reason for this is that Company D is not identical, rather it presents an expected decrease to earnings (via increased expenses) that Companies A and B do not have. That is, value should be based on the future, not the past. Companies can have low P/E ratios and not be cheap or worth buying as investors are expecting lower future growth, lower profitability or higher risk for this company. ?
Refocus on the Business Itself
The math with using P/E ratios is relatively simple (multiplication). This does not imply that valuation is simple. The challenge in valuation, therefore is not in the math itself or in processes and formulas that make it look complex, but in understanding the businesses and drivers of value and trying to determine when, how and why changes could occur. With less time spent on esoteric processes built solely on historical information we can more spend on time on forward-looking aspects. That is, we can focus on the main drivers of value: how the company is expected to perform via its revenues and expenses.
Importantly and as we just worked through, a P/E ratio alone does not tell us if a company is over or undervalued; rather, a P/E ratio tells us how the market, via its expectations of growth, profitability and risk, currently values the company. With this point of reference we want to consider the potential for revenue growth (or decline) and margin improvement (or decline) as well as the risk that our projections may not come to be or worse, the risk that the company will not continue to operate. With these expectations in mind, we can compare the company to others.
Stated differently, whether using a fully fleshed out DCF or relative valuation, in its essence, company valuation is a qualitative, quantitative and future-focused conversation on how the company is expected to perform over time via revenues and expenses.
Some Applications and Terminology
Here we will cover the specific pieces, applications and challenges of using P/E ratios for real companies. Again, the math we need for P/E ratios is relatively simple. This does not imply that valuation is simple.
Price to Earnings.
What is Price: Price is the current stock price of a company. It is what the company is trading at the day we are evaluating the company and considering the investment. Naturally, the price can change over time. We use tickers to represent a share of the company’s stock and we can find the price easily online (e.g., we can google the company’s ticker symbol). Walmart’s ticker is: WMT. Nvidia’s ticker is: NVDA. At the time I wrote this WMT is trading at ~$80 a share and NVDA is trading at ~$128 a share. By the time you read this, both prices will likely be different. Substantial changes to stock prices over time are relatively common, while substantial changes to stock prices within a day are not that common.
Finding the price is the easy part.
What Are Earnings: In the P/E ratio, earnings are not total Earnings or Net Income for the Company, but the Earnings or Net Income Per Share. Thus, Earnings Per Share is a representation of the Earnings that are attributable to a single share.
The P/E ratio is effectively the Price per Share divided by the Earnings Per Share.
We can find the company’s earnings per share by examining the Income Statement of their most recent 10-K. The number will be at the bottom. Earnings per share are also discussed in company highlights. Finding Earnings per Share is also. relatively easy. Moreover, we can also look up a company’s P/E ratio directly using Google. With the current P/E ratio in hand, we can compare it to the general P/E ratios across all firms, across time.[iii]
Ideally when we examine a company’s current P/E ratio we want to look at its Price as a function of its Core Earnings. That is, Net Income excluding truly non-recurring or one-time items. Using Core Earnings, not regular Net Income gives us a more specific reference point for considering the growth rate of future earnings. For more on understanding Net Income and Core Earnings, check out this post: The Flaws of Net Income: Completeness or this discussion covering Uber .
Core Earnings = Net Income after removing truly non-recurring or one-time items
This chart provides a depiction of average P/E ratios for the past 40 years. During this time P/E ratios generally hovered around 20x. This does not imply all companies should be worth 20x earnings.
Now, let’s examine three possible scenarios that could give rise to a long thesis (we'll set aside short thesis for this discussion):
Ok. Let's wrap it up for now. More to come. Part 2 continues with an application to 沃尔玛 and 英伟达 and offer some general comments on using P/E ratios.
The Link for Part 2 is now live too.
Take care,
PB
[i] For more on Short Selling, consider the class from Texas McCombs School of Business professor and renown short seller, Soren Aandahl.
[ii] Specifically, in the terminal period we expect constant growth rate, margins, efficiencies, capital structure and risk.
[iii] This is fairly similar to the choice that Warren Buffett and Charlie Munger of Berkshire Hathaway made when investing at Coca-Cola in 1988. At the time of purchase, Coca-Cola was trading at 18x earnings. The investment in Coke offered significant gains for Berkshire via stock appreciation and dividends.
[iv] The P/E ratio may also be based on the quarterly earnings for the trailing twelve months (TTM) or the expected earnings, not the most recent annual amounts.
[v] This is similar to Ben Graham’s cigar butt approach: the company is so undervalued that it will go up in value, even if the company is not as good as the general market. That being said, I personally would not invest in such a company, neither would Charlie Munger as covered in The Tao of Charlie Munger (e.g., Graham’s Error p. 22-23) and other recounting of Charlie’s approach to investing. As Munger elaborates, “If you buy something [just] because it is undervalued, then you have to think about selling it when it approaches your calculation of intrinsic value. That’s hard. But, if you can buy a few great companies, then you can sit on your a$$. That’s a good thing."
[vi] This last example of 1 of the 6 guidelines from David Gardner of the The Motley Fool 's Rule Breaking Investments as noted on the October 4, 2024 Episode, An AI IPO 20 Years of Rule Breaking https://www.fool.com/podcasts/motley-fool-money/ .
[vii] This section was added on November 3, 2024.
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1 个月Part 2 is posted: https://www.dhirubhai.net/posts/patrick-badolato-73505980_whymccombs-mba-math-activity-7250460150631669760-7Dec?utm_source=share&utm_medium=member_desktop
US REIT Analyst at B&I Capital
1 个月Great post Professor B. Totally agree with the point about simplifying DCFs to emphasize the core biz drivers to truly gauge value. Complex and impressive models are usually less informative and accurate than the simplest ones. I appreciated the emphasis on focusing on fwd estimates of earnings growth. As the market is generally looking out 6-12 months, I've found that it's more realistic to focus on next twelve month (NTM) P/E ratios when evaluating investment opportunities.