A common tendency while gauging valuation of companies is to estimate the one year forward multiple at which they trade. Our core investment approach is to “Buy Quality Companies at Fair Valuations”. However, Quality companies always seem expensive relative to the average ones when evaluated on this metric…which often lead investors to buy stocks that are cheaper- and often, walking with eyes wide open into a value trap.
As an example, I enclose our research on the multiples of two banks over time. One of them is a “quality” franchise per our framework, and the other not quite so. The data appended below shows that
- The Price/Book multiple differential between the two franchises was 54% at the start of our study period (31 March 2011).
- Analyst estimates suggest that this multiple differential premium will reduce to 2% if estimated on FY 2017 book value estimates. Our analysis further suggests that this premium will turn into a discount of approx. 17% based on FY 2020 estimates!!
- Hence, as we expand our time horizons, the multiple differential between a quality franchise and an average one narrows. Higher the growth differential, more rapid the pace at which the multiples will narrow.
Despite a 54% multiple premium at the start, the quality franchise has returned 22% CAGR over the period 31 March 2011 – 31 March 2015, while the average franchise has returned 0% (outperformance of 121% in absolute terms). The difference in stock price performance is explained by the superiority of one bank’s business model over the other: vastly different EPS growth rates, and equally importantly, difference in the “consistency” of earnings growth (see charts below)
The principal component of the value of a company comes not from its next year earnings, but from its terminal value. One year forward earnings are unlikely to contribute to more than 10% of a growing company’s value. Comparison on short term forward multiples across companies therefore results in significant underappreciation of terminal value differences between the companies. Einstein remarked that “everything needs to be made as simple as possible, but no simpler”. One year forward multiples are very useful to gauge the valuation of the market or company relative to itself over time. Using this metric to make investment choices between companies, without digging deep into the underlying strength of a business model and the growth rate it is likely to deliver, will likely result in sub optimal investment choices.
|Leading Private Sector Bank||FY11||FY14||FY17E||FY20E|
|P/B Ratio (Price as of 31st March 2011)||4.3||2.6||1.4||0.8|
|Leading PSU Bank||FY11||FY14||FY17E||FY20E|
|P/B Ratio (Price as of 31st March 2011)||2.8||1.8||1.4||0.9|
|Valuation Premium (Leading Private Sector Bank to Leading PSU Bank)||FY11||FY14||FY17E||FY20E|