By Mark Melin. Originally published at ValueWalk.
A stock multiple is, at its most basic level, the measure of “value” in the market. In its purest form, a multiple reflects the relationship between a stock price and its earnings. In traditional investment models, a company’s potential to earn a return on capital was the immediate performance driver in evaluation. The problem with simple price stock multiples is they don’t reveal important truths about a business operation, a UBS Global Research report on valuations and accounting points out. For its part, UBS has a desire to create a new multiple formula that addresses the nuance in how a company operates underneath the hood.
Why do similar stocks have different P/E multiples?
Why does one company in a particular stock sector sell at a price / earnings ratio of 12x earnings while another company operating in the sector sell at 16x earnings?
UBS Analysts Geoff Robinson and Guy Weynes think “a valuation multiple is simply an expression of relative value to a related key statistic.”
In many cases that statistic is the most fundamental performance measure of a business – profitability. While earnings remain a key metric, other multiples look at cash flow, user growth or consolidated market share to measure a firm’s value. Whatever the formula, it “must bear a close enough relationship to the observed value that it could be considered a driver of market value.”
“Multiples are much more likely to capture the impact of market sentiment than a discounted cash flow valuation, Robinson and Weynes wrote in a piece titled How to…analyse and talk the language of multiples. “Well-put-together multiples can be an effective communication tool as well as a valuation device.”
stock multiples, Valuation formulas have common features
To build a better multiple, Robinson and Weynes built an interactive multiple tool that allows investors to model target multiples based on fundamental drivers.
The UBS model uses both financial and non-financial metrics. In addition to just calculating the earnings, the driver of earnings is considered in the formula. For instance, proven oil reserves or unearthed gold for miners tell the story of earnings to come and can be included with the proper formula structure.
“This allows analysts to understand the underlying drivers of what supports a multiple, thus providing a better insight into what drives value,” Robinson and Weynes reason, noting that multiples are about valuation judgments. “When used properly, multiples are robust tools that can provide useful information about relative value.”
The best investment formulas are often based on simplicity and relevancy, but one must be cautious not to make the formula too simple or build one that is difficult to compare from company to company. For instance, many price earnings ratios include non-recurring items in the formula, which tends to distort the numbers on a one-time basis.
An “Enterprise Value” multiple, for example, is determined by measuring the equity value – the claims of shareholders on capital) relative to net debt, which includes pension provisions, and then considers minority providers of capital. There are numerous methods to evaluate enterprise value, with variables in core asset values being one of several points of formula differentiation.
Consistency is a variable that is important on several levels, including how they are weighted and measure asset values across companies. “Ultimately multiples are simple fractions that must be consistently prepared. As we have mentioned before, the denominator and numerator must be comparing ‘apples with apples.’”
A degree of consistency can be found in most multiple formulas. “Fundamental valuation in its most simple form is a function of: (1) cash generation (2) risk and (3) value added growth.” The issue is how these are measured and modeled.
The post Stock Multiples Grow More Complex, But Consistency and Relevance Remain As Benchmarks appeared first on ValueWalk.
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