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In my last article, titled Why Oracle Focuses on Quality and Our Preferred Holding Period is Forever” I mentioned in passing that “simple P/Es can be misleading” and “different companies will have a different fair value P/E”. I said that it was beyond the scope of that article, so I dedicated an entire article to the topic, as it is a very important concept in investing, not least because the P/E (price/earnings) ratio is probably the most widely used (and misused) financial metric in the investing industry. 

Put simply, the price to earnings ratio measures how many years of profits the investor is willing to pay to buy this business. It is calculated by taking the share price (the ‘P’) and dividing it by the earnings (the ‘E’). Typically investors will use either last year’s earnings or an estimate of next year’s earnings. We prefer to look at next year’s earnings because the market looks forward and uses future prospects to value companies. 

But this is where things get interesting and views diverge because you bring into the equation estimates. As soon as estimates are involved there will be differences of opinion and that is precisely what makes a market. 

The conventional wisdom is that the P/E a company trades on will be a reflection of the market’s sentiment towards the business and its future growth prospects. This is true to an extent, but it also reflects so much more – and less!

However to understand a P/E you have to first understand how the market values companies in the first place. Views differ here, but we believe that:

The market values companies based on the present value of the discounted value of all (estimated) future cash flows.

 You might be asking, “Well what on earth does that mean?”

A Very Brief Primer on Discounted Cash Flows

A fair enough question. This basically means that investors in the market, as a group, will forecast what the company can potentially earn in terms of free cash flow (note: we are talking about cash in the door – physical cash flows from business operations – less capital expenditure, not accounting earnings here). That’s the “future cash flows” part of the equation. 

Due to the time value of money, these future free cash flows need to be discounted back to a present value. If you understand compound interest you can understand discounting to the present value because they are opposites. The time value of money means a dollar today is worth more than a dollar in one year’s time because that dollar today can earn interest at least to the value of the risk free rate. For simplicity, we’ll just define the risk free rate as the 10 year government bond yield and we’ll assume it is 5% in this case.

To put some numbers around this, if someone offered you $100 today, how much would they need to offer to pay you in one year’s time for you to accept the offer of money today? You could grow today’s $100 5% to $105 without any risk, so the minimum you should accept in one year’s time is $105. If the question was for 2 years, the minimum you should accept is $110.25, because you could grow your $100 by 5%, then 5% again to $110.25.

The $100 is called the present value. The $110.25 is called the future value. The $5.00 and $5.25 of interest are the cash flows in years 1 and 2. At a 5% discount rate, $100 today is mathematically equivalent to $110.25 in two years’ time.

This is what the market does. It forecasts the future free cash flows of a business, uses a discount rate, and discounts these cash flows back to the present value to come up with a company valuation. The discount rate used won’t be the risk free rate because company earnings are far from risk free, but you’ll be pleased to know that the method to determine an appropriate discount rate is beyond the scope of this article.

    Applying this to Multiples

    You might now be thinking, “We’ve spent all this time talking about discounted cash flows and nothing about multiples. What gives?” 

    Another fair question, but it is intrinsically related because the “fair value P/E” (remember this term from the opening line?) is simply the P/E of the stock at your DCF value. So the market will come up with a value for a stock (using a discounted cash flow, or DCF), and the company P/E will be determined by this DCF value.

    The inverse is not true: the market does not assign a P/E to a company’s earnings to determine what it will trade at. 

    I cannot overstate this, because it is a common misconception in markets. 

    Similarly, we might have wildly different assumptions about the market and produce our own DCF based on our own research and assumptions. Differing views, opinions and analysis are what make a market after all. The “fair value P/E” is simply the P/E of the stock at your DCF valuation. So determining a fair value P/E is no different to determining your estimate of intrinsic value for the company. 

      Return on Invested Capital

      In my previous article, I wrote of the importance of return on invested capital (ROIC). In this article, I want to take that assertion one step further and demonstrate its importance in determining a fair value P/E. 

      In a discounted cash flow model, the cash flow number is determined by taking the after-tax operating income (or EBIT), subtracting estimated capital expenditures required for growth, subtracting estimated investment in working capital, and adding back depreciation and amortisation. 

      This is an important explanation for understanding the concept of fair value P/Es because a company that is expected to earn 10 million dollars in net income next year may need significantly higher capital expenditures than another to do so. These capital expenditures will reduce the free cash flow available to shareholders as dividends or reinvestment in the business.

      Putting this into Practice

      Let’s put some numbers to it. We have two companies: Widgets Ltd (WID), and Gizmos R Us (GIZ). Both companies earned $10m net income last year. Both expect to grow their net income by 8%. But growing net income requires investment in the business (capital expenditure, or capex). How much investment is required is determined by the return on invested capital the companies can achieve.

      If WID earns a 10% ROIC, to earn an incremental $0.8m (i.e. 8% growth on the $10m net income), it will need to invest $4m in capex ($8m x 10% = $0.8m). Out of the $10m net income the company earned last year, this leaves $4m available to shareholders.

      If GIZ, however, earns a 25% ROIC, to earn an incremental $0.8m, it will need to invest ~$3.2m ($3.2m x 25% = $0.8m). Out of the $10m net income earned last year, GIZ will have $6.8m available to shareholders.

      To bring this back to the previous discussion, the $4m and $6.8m available to shareholders is the cash that is effectively available for dividends. It is the free cash flow that will be discounted in the DCF. Both companies have earned the same net income number ($10.8m), and both companies have grown at the same rate (8%), but the company with the higher ROIC has more cash leftover.

      We can use the Gordon Growth Model (GGM), which is the simplest type of DCF to calculate the share price of these companies. But first, we will need a discount rate. (You’ll be pleased to know that determining an appropriate discount rate is beyond the scope of this article as well, as is a detailed exposition of the Gordon Growth Model). In this instance, let’s use the long term average return of the S&P/ASX All Ordinaries, which is about 9%.

      The formula for the GGM is P = D1/(r-g).

      Where D1 is next year’s dividend, r is the discount rate, and g is the growth in the dividend.

      Let’s plug our numbers in for our companies:

      WID — P = 2/(0.09-0.08) = $200m

      GIZ — P = 6.8/(0.09-0.08) = $680m

      On the same level of earnings, earnings growth, and discount rate, GIZ has a higher share price. Now let’s look at their P/Es.

      Recall that both companies will earn $10.8m.

      WID — P/E = 200/10.8 = 18.5

      GIZ — P/E = 680/10.8 = 63.0

      Would you pay 63x earnings for a company growing at 8% per annum? If they are earning 25% ROIC (which is 14 percentage points higher than their cost of capital), you should consider it.

      This can go some way to explaining why companies like WiseTech Global (WTC) and Pro Medicus (PME) trade on seemingly ridiculous multiples: because they can reinvest their profits at high rates of return, growing their earnings efficiently, leaving high levels of cash available for capital dividends or investment.

      Concluding Remarks

      This analysis is illuminating as a theoretical exercise, but surprisingly not very helpful if you try and apply it directly to a high growth company. The reason is that the simplistic Gordon Growth Model DCF doesn’t work if the denominator (which is the discount rate minus the growth rate) is negative. The way this is solved is to use a multi-stage DCF, which forecasts future cash flows with more nuance. This will still provide a valuation as we computed above, just using a different calculation. Once you have a valuation, you can calculate the P/E, which you can use as your fair value P/E. 

      The higher quality companies can produce growth in earnings with far lower capital investment and therefore enable a higher level of cash available to shareholders for either dividends or reinvestment into the business for yet more growth. And that note, I believe closes the circle as to why we at Oracle focus on quality companies and are less concerned about what multiple a company trades on, because our estimate of intrinsic value — which is heavily influenced by the company’s ROIC — is more important.

       Note: I am indebted to Bleiberg and Priest of Epoch Investment Partners who articulated so clearly the mechanics and arithmetic of the above discussion, from which I have drawn.

      Please reach out to us about your financial goals and we will provide guidance on achieving them.

      Important information – Oracle Advisory Group makes no representation or warranties as to the accuracy or completeness of any statement in it including, without limitation, any forecasts. The information in this document is general information only and is not based on the objectives, financial situation or needs of any particular investor. An investor should, before making any investment decisions, consider the appropriateness of the information in this document, and seek their own professional advice. Past performance is not a reliable indicator of future performance. The information provided in the document is current as the time of publication.
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