In a recent white paper, Epoch’s chief executive and chief investment officer, Bill Priest, explored this very theme of price to earnings (P/E) ratios.
The job of an active global equities manager is to identify alpha opportunities — situations where the market price of a stock is incorrect. But it’s not enough to simply decide what an investor believes a stock is worth and then compare it to the market price.
Part of the process of deciding that the market price is incorrect has to involve figuring out what assumptions the market is making about the three key variables — the company’s free cashflow, its growth rate and its cost of capital — that drive the fundamental value of the business. Without that analysis, investors are not making an informed assessment.
Too often, argued Priest, investors do not perform this kind of analysis. Rather, they rely on valuation metrics like the P/E ratio or the price to earnings to growth (PEG) ratio, treating them as if they are fundamental characteristics of a stock in their own right.
But, without an understanding of how a company’s return on invested capital (ROIC) is driving the trade-off between its free cashflow and its growth rate, those ratios can be worse than useless. They are simply not a reliable guide to valuation on their own. In many situations, investors use P/E or PEG ratios in a way that implicitly assumes a static world. But the world is dynamic; relationships change constantly. P/E ratios can herald that change, but only if investors are alert to the information they carry.
Rather than making assumptions about how the P/E will change based on historical averages, the job of an investor is to figure out what assumptions the current P/E is signalling, and then to make a judgement about whether those assumptions are likely to prove true.
The more convincing investment thesis is not “Company X is attractive because its P/E is below its long-term average,” but rather “Company X is attractive because the current P/E underestimates the improvement in ROIC that the company will achieve.”
APPLICATION OF P/E
In his white paper, Priest argued that P/E ratios are the most widely used valuation metric in the investment world, but that they are also the most widely misused. Most people use them in a way that renders them meaningless. Properly understood and properly used, though, the P/E ratio can be a valuable tool for deciphering the coded information that every stock price contains.
In any market system, prices contain information. The problem is, it’s not always easy to figure out what that information is. When the price of a stock goes up, it is rarely easy to draw an obvious connection between a specific piece of information and the change in price. Investors are left to fall back on models about which kinds of information matter to market participants, who ultimately determine the price of a stock through their trading with one another.
The most sensible way to determine what a business is worth is to perform some variation of a discounted cashflow (DCF) analysis: estimate what cashflows a company will throw off to its owners over time, and then discount those cashflows back to their present value. This is the best model to apply. Similar to if you were going to put up the money to buy a business in full, the DCF approach captures how you would put a price on the business and, indeed, this is how private equity firms generally value businesses.
Also, for publicly traded businesses, there is an arbitrage opportunity if the stock price deviates too far from what a DCF analysis says the company is worth. If the price is well below what the DCF model says it should be, an investor (such as a private equity firm) could buy the entire business and capture that undervaluation. If a stock appears to be well above its DCF price, an investor could sell that stock short and take a long position in the stock of a similar business that is trading closer to its fair value.
Theoretically, this arbitrage opportunity should act to keep stock prices from straying too far from their fair value for too long, making the DCF analysis a good way to estimate the fair price of a stock.
The most well-known DCF model is the dividend discount model, which uses dividends as the cashflows to be discounted. At a public company, this cashflow can be distributed to shareholders either in the form of cash dividends, stock repurchases or debt reduction, all of which are functionally equivalent.
Following the relevant analysis and on the hypothetical basis that two companies with the same amount of revenue and net income could pay out very different dividends, investors need to be asking how and why that is the case.
An important part of the answer is that different companies require different amounts of reinvestment in their business in order to make it grow. The more you need to reinvest to achieve growth, the less you have left to pay out to shareholders, and vice versa. And that variation is driven primarily by differences in ROIC that companies earn.
THE NEED FOR ROIC
Take ABC Corporation and XYZ Industries, for example, with both having earnings of $1 per share. Both companies would like to grow their earnings by 6% over the next year. What would it take for each company to do that? Earnings growth requires investment of some capital to expand the business. How much capital would each company have to invest in order to achieve a 6% increase in earnings?
The answer clearly depends on what kind of return each company can earn when it invests capital in its business, and how much additional profit is created for each dollar of capital it invests. And much of this is dependent on the reinvestment rate.
When one company has an ROIC that is twice as high as another’s, in order to achieve equal rates of profit growth, the one with the lower ROIC will have to reinvest twice the proportion of its profit as the company with the higher ROIC. But that means that the company with the lower ROIC also has less money left to distribute to shareholders.
GROWTH AND FREE CASHFLOW
Every company faces the same dilemma – the faster you want to grow, the more of this year’s earnings you need to reinvest. But the more you reinvest, the less free cashflow that leaves for you to distribute to shareholders. Conversely, a higher distribution to shareholders will, on its own, tend to raise the price, but it means sacrificing some reinvestment and settling for a lower growth rate.
Typically, as ROIC increases, the reinvestment rate needed to achieve any given growth rate declines, and the distribution rate rises. The fact that two companies have the same growth rate does not mean they should sell at the same P/E multiple. Higher ROIC is always better than lower ROIC, even for companies with the same growth rate.
Strangely, Priest’s analysis found that when a company’s ROIC is exactly equal to its cost of capital, it doesn’t matter how fast or slow the company tries to grow, the value of the business doesn’t change at all even as growth increases. This conclusion is indicative of the difference between earnings and free cashflow; what drives the value of a business is not its earnings, but how much of those earnings end up in the hands of the shareholders (versus how much has to be reinvested in the business).
If a company can earn more on its investments than the cost of the capital invested, it’s creating value, so the more invested, the greater the value created. If a company earns less on its investments than the cost of the capital, it loses money on every dollar invested. The more you invest, the more you lose. And if investments earn just enough to pay off the cost of the capital, it’s a wash. You don’t make any money, but you don’t lose any money. You could invest more, but it won’t make any difference; you’ll still just come out even.
Current free cashflow and future growth both drive the value of a business. But there is an inherent trade-off between the two, and the variable that ultimately triangulates the outcome of that trade-off is ROIC.
Epoch’s global equity investment approach is designed to uncover opportunities that others may miss. In its view, growth of free cashflow, and the intelligent use of that cashflow, represents the best predictor of long-term shareholder return. It looks for strong company management with a commitment to financial transparency and a track record of delivering returns to shareholders.
Damien McIntyre is chief executive of GFSM.