Equity Multiples: Myths, Mania and Alchemy – A Valuation Riddle … Wrapped in a Mean Reversion Mystery … Inside an Accounting Enigma
26 Pages Posted: 14 Oct 2020
Date Written: July 12, 2020
The paper is a practitioner validation of the well-known yet conveniently ignored reality that equity Multiples such as the popular Price Earnings Ratio have essentially no theoretical foundations as economic value metrics; they are effectively a matter of market convention and convenience. Multiples are preferred over gold standards of valuations such as the Discounted Cash Flow (DCF) methodology on the ground that the former is easy to calculate while the latter requires a substantial amount of explicit assumptions such as profit margins, discount rate, and growth rate, thus making the results of the discounting exercise unreliable. The paradox is that the same input and assumptions used in the DCF are required for the variables used to calculate the Multiples. The difference is that these variables are explicitly quantified in the DCF while they are implicit in the Multiples, i.e. decided by someone else and “concealed” in one number. The paper exposes this point analytically by equating Multiples to universally accepted valuation principles, thereby establishing a clear link and dependence of Multiples to fundamental drivers of economic value. Using descriptive arguments, the paper then debunks the “secular” bedrocks for Multiples application, such as the practice of assessing “value” by comparing Multiples across arbitrary benchmarks - e.g. history, comparable, markets, countries, etc. - and then relying on mean-reversion strategies to “arbitrage” discrepancies. Lastly, the paper echoes the admonition of confusing accounting Earnings with Economic Earnings, thus providing support to those quipping that “Cash(flow) is a fact, Earnings is an opinion”. Ultimately, the intended contribution of this paper is to catalog these arguments all into one place, and for the practitioner’s consumption. The conclusion and the advice are that Multiples, given their widespread and obstinate popular use, should be considered at best as momentum and sentiment indicators, worshiped by speculators and shunned by fundamental investors.
Keywords: Equity Multiples, Price Earning Ratio, Equity Valuation, Discounted Cash Flow, Value Investment, Stock Selection, Finance, Financial Economics, Accounting
Suggested Citation: Suggested Citation