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MAIN STORY: UNDERSTANDING PRICE MULTIPLES

As a follow-up to her past piece on mean reversion, Rebecca Hotsko, the host of our Millennial Investing podcast, joins us again today to discuss why multiple expansion/contraction is a critical component of your investment return.

She writes the following.
 

Getting started

Price multiples are often thrown around, but people usually fail to interpret them within the proper context. Interestingly, Pavilion Global Markets found that price-to-earnings multiple (P/E) expansions drove 21% of the S&P 500’s returns since 2011.

In other words, investors paying more for the same amount of earnings was a huge contributor to investment returns.

Predicting where a company’s price multiple will be in the future is no easy task, though. Several factors cause multiples to change over time, some of which are impossible to predict.

Factors that cause multiples to change over time: 

• The level and growth rate in earnings per share
• The perceived riskiness of the stock or risk of receiving these future cash flows (which shows up in the discount rate)
• The expectations of inflation, interest rates, equity risk-premium, and specific company risks (which also show up in the discount rate)

Volatile multiples

Let’s look at Alphabet (GOOGL) as an example — and I’ll just refer to them as Google to keep things simple.

The company has grown earnings per share (EPS) by an average of 27.5% over five years. Yet, over this same period, its multiple has fluctuated substantially, falling from 58x earnings in 2017 to 17x in 2022.

Source: Macrotrends

What’s happening with Google?

Despite Google’s solid growth in EPS since 2018, its multiple is much less today than in prior years, when it earned far less.

The market is forward-looking, so it may believe that Google’s growth prospects have changed, likely slowing. Therefore, it doesn’t warrant as high of a multiple anymore.

This aligns with declines in analysts’ estimates for Google’s EPS growth for the next five years of 9%, much lower than its previous five-year EPS growth of 27.5%.

Google is not a recession-proof business. Some of the multiple contraction recently could reflect recessionary risks facing the company as the market grows concerned about receiving those expected future cash flows, which would justify a lower price paid today.

External factors

The tricky thing is that not only is a company’s multiple based on its future growth prospects, but also several external factors that are impossible to predict, including interest rates, inflation, and recessions.

For example, low-interest rates kept multiples artificially high for years by reducing the risk-free rate used to value equities, aka the discount rate.

Similarly, low inflationary periods have also historically led to lower discount rates, which means a higher multiple than higher inflationary periods.

Elevated inflation injects uncertainty into every layer of the economy, and this uncertainty causes investors to demand higher future return compensation, resulting in higher discount rates and lower price multiples.

What to know

A company’s earnings growth is just one piece of the puzzle in determining where the multiple will be.

Additionally, external factors can override positive earnings growth and suppress multiples.  As a result, a company’s multiple will fluctuate considerably over time. Still, it’s crucial to remember that historical multiples are not necessarily a good predictor of where it will be in the future.

So what is the right multiple to use? 

Empirical evidence from Jing Liu, Doron Nissim, and Jacob Thomas found that forward-looking multiples are more accurate value predictors.

They compared the performance of historical and forward industry multiples for a subset of companies trading on various U.S. exchanges and found that forward-looking multiples had greater accuracy.  Moonchul Kim and Jay Ritter found similar results when they compared the pricing power of historical and forecast earnings for 142 initial public offerings.

Downside of forward multiples

That said, using forward estimates has downsides. Because they’re based on Wall Street’s consensus earnings estimates, they’re subject to significant room for error. Predicting the future is no easy task.  It’s always worth double-checking the implied growth estimates embedded in these forward estimates.  Looking at Google, its current P/E is approximately 17.6x earnings, and its forward P/E is 17.0x, which means that this assumes Google will grow earnings next year by 5-10%.  So, while forward estimates are empirically supported as a better and more reasonable estimate of where next year’s multiple will be, it still requires your own due diligence.

What about in the long term?

As mentioned in my discussion of mean reversion, a more conservative estimate to use long term is to assume that the multiple will move toward the industry average over time, which is about 19.7x earnings currently.

Google trades for a multiple less than this, and on top of that, it’s trading at a multiple within the lowest range of its history.

This suggests that the risk of further multiple contraction is reduced, leaving room to potentially benefit from future multiple expansion.

Wrapping up

It’s worth mentioning that although I am showing the P/E multiple for simplicity, this is often not the best multiple to use for all companies, especially high-growth companies with volatile earnings.

It’s often best to take a combined approach and look at a range of multiples that are most suitable for the business and industry.

Dive deeper

If you didn’t read Rebecca’s write-up on mean reversion, you can check it out here.

And make sure you subscribe to the Millennial Investing feed on your favorite podcasting app to hear more of Rebecca!