Why bad multiples happen to good companies

By Peeyush Karnani , Sophia Yue W. , and Vartika Gupta, CFA

Earnings multiples, particularly the price-to-earnings (P/E) ratio, are a common shorthand for summarizing how the stock market values a company. Investors and analysts often use them when talking about how they value companies.

The fact that there are more detailed models behind this is rarely discussed. So, we often have executives worrying that their multiple should be higher than the one the market currently awards them. “We have great growth plans,” they say, or “We’re the best company in the industry, so we should have a substantially higher earnings multiple.” Their logic isn’t necessarily wrong. Finance theory does suggest that companies with higher expected growth and returns on capital should have higher multiples. And the theory held true when we analyzed large samples of companies across the economy.

However, our analysis showed that the differences in multiples if analyzed correctly may not be meaningful among true peers within mature industries. Multiples are a result of a company’s performance and expectations. Companies may occasionally outperform their competitors, but industry-wide trends show a convergence of growth and returns that is so striking as to make it difficult for investors, on average, to predict which companies will do so.?Managers would be better off focusing instead on growth and return on capital, which they can influence.

The trouble with multiples

1. Investors evaluate companies based on what they are, rather than what they aspire to be.

Many executives who worry that their multiples are too low are simply comparing their company with the wrong set of peers or making a comparison with peers at a different stage in the cycle. However, the only relevant comparable companies, for the purposes of multiples analysis, are those that compete in the same markets, are subject to the same set of macroeconomic forces, and have similar growth and returns on capital.

2. Some multiples are also better than others for comparing performance.

P/E ratio is distorted by differences in capital structure and other non-operating items (Exhibit 1). As a result, most sophisticated investors compare companies relative to peers using either EV/EBITA or EV/EBITDA, which are not burdened with the distortions that affect earnings ratios.

3. However, comparisons based on enterprise-value multiples typically reveal a very narrow range of peer-company multiples.

a.???? One explanation is that investors tend to assume all peers will grow at roughly the same rate over the long term. However, companies that are growing faster than their peers today are not likely to continue growing faster than their peers for the next five years. Across the economy, we have found substantial convergence of revenue growth across companies (Exhibit 2). Even energetic efforts to communicate to investors that a company will grow faster probably won’t help, since almost all companies predict they will outgrow their market, and investors know that equity analysts are consistently overly bullish.

b.??? According to finance theory, companies with higher returns on capital than their peers should also have higher multiples—but in fact, these companies’ multiples are not as high as one might expect if investors believed their stronger returns were sustainable (Exhibit 3). The logic could be that investors assume incremental returns on capital across the industry will converge, or that competition will bring them down toward the cost of capital.?Investors appear to assume that acquisitions will continue to eat away at returns on capital.

What should executives do? Keeping the focus on value

Of course, not all investors will be so skeptical about a company’s ability to outperform its peers. Sophisticated investors (or intrinsic investors, as we call them) do place their bets that some companies will outperform others based on their examination of the company’s track record, competitive position, strategy, management strength, and credibility.?

Executives should focus on the amount of value they create—with regard to growth, margins, and capital productivity, to drive total shareholders return (TSR), rather than solely aiming for a higher earnings multiple. Setting realistic expectations about how much they can raise their share price above those of peers through investor communications is also important, as is understanding that there are limits to how much investor communications can elevate share prices above their peers, and that investor perceptions tend to converge over time. Executives would do well to engage effectively with investors by maintaining clear and strategic communication with the right investors to ensure they understand the company’s performance and strategies, helping to keep the share price aligned with those of peers.

Multiples is an important topic not just for executives but analysts and investors and there are several nuances when analyzing and using the multiples.

We’ll cover more of that in the coming weeks, so watch this space for more.