Why you should use more than one metric when valuing a company
When considering companies to invest in, there are a range of valuation techniques you can choose from. Each has its own flavour – its unique merits and pitfalls. But which one to use? Or should you use more than one?
Some common valuation techniques include discounted cash flows (DCF), sum of the parts (SOTP), quantitative ranking, company comparables, or multiples.
For companies which are conglomerates, or perhaps have non-core lines of work, SOTP can be a very useful metric, particularly when there are different drivers for various components. However, if using a SOTP approach, each individual component needs to be valued accurately. As with DCF, there can be a danger in becoming too granular (some more detailed thoughts on that here).
The most common and theoretically sound method is DCF. It is based off the true ‘value’ of a company – being the present value of its future cashflows. However, to accurately predict these you need to make a large range of assumptions – how fast are revenues growing? What will happen to margins over time? How much capex will be deployed? What is an appropriate weighted average cost of capital (WACC)?
With each of these questions we add a layer of complexity, particularly as each of these questions is the tip of the iceberg. To accurately predict revenue growth you need to understand whether the competitive environment is changing, how the industry is going, whether new verticals/ horizontals are being explored etc. Does the company have a true competitive advantage? What quality of business is it? How long would it take a competitor to displace it? Suffice to say – it’s hard to predict an uncertain future.
A less granular approach would be to use a multiple, the most common of which is P/E (a measure of what multiple of earnings the current price implies). This ratio is straight-forward to calculate (and often even provided in guidance by company management). However, the easiest solution is rarely the best, and there are often pitfalls that it encourages. For example:
- High growth companies often have deceptively large PE multiples. When Google listed in 2004 on a PE of 80, many well-regarded market players rejected the offer. To be valuable Google would have to earn more than 80x its current year earnings (discounted to listing day). It would certainly have required a lot of imagination to envision that much growth (and impossible without understanding the competitive landscape and growth potential).
- Declining businesses can have inflated PE multiples. If a business will go bankrupt tomorrow, even a 1xPE multiple may not be cheap.
- PE ratios do not incorporate debt/ equity ratios and the cost of capital. A highly levered manufacturing company on 20x earnings has more inherent risk (all else being equal) than a net cash technology company on 20x.
- Looking at any one given year earnings multiple can be a skewed data point when significant events have occurred.
Where P/E can be useful is comparing if the market is pricing the business at a premium or discount to peers or historical levels (as long as you’re also questioning whether this is appropriate for the present risks and different quality of earnings).
So, in a nutshell, much as a DCF valuation increases granularity, a P/E multiple reduces it to one number. Using it in isolation (without questioning the growth trajectory, cost of capital and changing industry structure) risks missing opportunities and overvaluing things by assuming the status quo. Sometimes, the devil is in the detail.