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Portfolio Strategy

Multiple’s Personality Disorder

In this article, Cameron Hight discusses the pervasive use of PE multiples (Price-to-Earnings) to value stocks and what we use Multiples for.

The pervasive use of PE multiples (Price-to-Earnings) to value stocks has always been perplexing to me. What do we use Multiples for? To help us make a more informed investment decision. Well let’s put that to the test and say that I’m evaluating Google. I determine that the PE multiple is 20x Earnings Per Share (EPS). What does that really tell me? It tells me that if Google’s EPS remains flat in the future, I will double my money in 20 years. Sure, that’s informative, but wouldn’t a better perspective be to say that Google has an earnings yield of 5%? I know it is just the reciprocal (1 / 20) but it seems so much more informative. Just like 60 miles per hour is more informative than 0.02 hours per mile.

If I were running a fund, I would require my analyst to speak in terms of yield instead of multiples. When you tell me that Google is trading at 20x and Citigroup is trading at 10x, I understand that Citi is cheaper on a pure multiple basis. But it seems much more informative to know that Google is yielding 5% while Citigroup is yielding 10%. This makes the appropriate asset class comparison more obvious. I can get a money market yielding 1%, a treasury yielding 2.5%, a muni yielding 4% or Google yielding 5%. This seems like a more proper framing of the equation.

In addition, a small change in low multiple stocks can have a large impact in yield but have the opposite impact on higher multiple stocks. In the chart below, a multiple expansion from 6.5x to 10x lowers the yield from 15% to 10%. Clearly an investor would prefer to pay 6.5x instead of 10x, but understanding the yield has decreased to 10% makes decision making more exact. For a more profound reason to use Yield, see the top end of the scale (Assets #1-#5). A large multiple shift from 50x to 75x barely nudges the earnings yield.

A savvy investor will quickly point out that all of these arguments are flawed because we’re not including growth. I agree. I may be willing to buy stock trading at 75x if it’s growing 75% a year. The problem is that both multiples and yields are point in time snapshots. The PE-to-Growth (PEG) multiple is an attempt to account for growth, but it doesn’t do a great job (see the chart below). If we divide PE by growth, we get a series of 1.0x PEG assets. I would argue that their identical PEG does not equal identical investments. Assuming you would rather have a dollar today than tomorrow, you would prefer Asset #13 with a 100% yield and 1% growth more than Asset #1 with a 1% yield and 100% growth, but the PEG doesn’t differentiate between the two. A better method is to use a Forward Yield (Current Yield * Growth) which gives an advantage to current dollars versus future dollars.

The idea of favoring current dollars (higher yield) rings empirically true when the analysis is stretched beyond one year to look at the cumulative yield over 5 and 10 years. However, growth starts to catch up with yield quickly in the 10 year analysis. Asset #1 had the lowest Forward Yield above (2%), but after 5 years, its Forward Yield (31%) is better than Asset #2 (27%) and #3 (26%). After 10 years, Asset #1 (1023%) is better than all assets except Asset #13 (1046%). Of course, this assumes that Asset #1 can actually grow earnings by 100% a year for 10 years, but the conundrum is still apparent. How do I use Multiple or Yield to measure the investment qualities of an asset?

The answer is that you cannot use point in time valuations like Multiple or Yield to correctly assess an assets value. They are good heuristics when doing a superficial
initial analysis, but fall short when compared to a discounted cash flow analysis (DCF). A DCF allows for varying degrees of growth, expenses, and time value. All of which are necessary to properly characterize the investment value of an asset. So in the pecking order of valuation methods, the Multiple gets bottom billing but, for some reason, is still the most used metric in the industry. Going forward, remember this simple equation: DCF > Yield > Multiple. It’ll help prevent you from Multiple’s Personality Disorder.

Portfolio Strategy