Is That Stock Attractively Valued? Your Beloved Multiples May Fool You

I bet that most of you have come across articles, podcasts, or televised “expertise” on the “value vs. growth investing” topic…

It keeps coming up in all kinds of economic circumstances.

To tell you the truth, I find such discussions amusing but absolutely pointless.

Let me show you WHY…

As you probably know, value investing is mostly defined as buying stocks with low price-to-book (P/BV) or price-to-earnings (P/E) multiples. But did you know, that these multiples are anachronistic and outright unreliable in today’s market?

Once you discover how better quality data can provide an edge in the highly-competitive market of stock investing, you’ll be amazed how low-level most media coverage is…

The media is there to get your attention and keep hold of it as long as possible, but they are not in the business of making you a better investor. (It’s pretty costly to believe the opposite.)

Bear with me, and you’ll learn more from this single article than what CNBC could teach you in a decade.

Times Change, the Core Principle Doesn’t

The core principle of value investing is almost 100 years old, yet it is totally unchanged: always invest with a margin of safety. This means that the stock you are buying must be priced at a huge discount to the underlying company’s intrinsic value. The part of the concept that is constantly changing is how you come up with the intrinsic value of the business.

Back in Ben Graham’s time (who is often referred to as the father of value investing), just after a depression, a company’s intrinsic value was defined as its liquidation value. Investors used the balance sheet to carry out conservative calculations to determine what shareholders would get if all the assets were sold and all liabilities were paid.

This is how they did it: Net Current Asset Value (NCAV) equals the company’s current assets minus its total liabilities (including preferred stock). Once you divide this NCAV by the number of shares outstanding, you’ll have a pretty good idea of what dollar amount a share may be worth if the business were to be liquidated.

Paying a much lower price than this was an approach that worked like a charm for over 40 years since stock prices were generally quite tightly tied to book values, and patient investors could often find companies that were out of favor, trading below estimated liquidation value.

As Bill Nygren, portfolio manager at The Oakmark Funds points out, “It was an asset-heavy economy, which made it appropriate to value businesses based on their tangible assets. In fact, as recently as 1975, 83% of the stock market value of the average company was represented by its tangible book value.”

Okay, now fast forward to today…

A lot has changed since then. Today you’ll see a much more asset-light economy, where intangible assets (like brand names and patents) account for over 80% of the average company’s market value.

(Just think about the industrial era when factories equipped with heavy machinery appeared on the balance sheet, compared to the intangible value of brands and software algorithms that is “invisible” to investors today.)

As Nygren puts it, “The linkage between book value and business value has been broken because so many important assets today are intangibles and don’t even show up on the balance sheet. […] For companies in the S&P 500 today, the correlation between stock price and tangible book value has become quite small, just 14%. This is a very big change from 25 years ago when that correlation was 71%—or 5x stronger than it is now.”

Here’s what Warren Buffett had to say about this shift: “My own thinking has changed drastically from 35 years ago when I was taught to favor tangible assets and to shun businesses whose value depended largely on economic goodwill.” Times are changing, don’t fall behind!

Here’s a sure bet: In hindsight, you must agree that buying Amazon’s stock at $600 around January 2016 would have been a great idea. The thing is that the P/BV multiple of ~26 would have suggested otherwise. That valuation metric was crying SELL at that time, while Amazon was creating shareholder value on a formidable scale. (I’ll show more on this later.) P/BV clearly doesn’t have much to offer in the modern economy, period.

Okay, but what about earnings?

It is no surprise that most investors have turned to the earnings power of the companies to determine their intrinsic value. Too bad the income statement fails them just like the balance sheet did!

The problem is that the income statement no longer provides a reliable indication of the value a company created in a particular year.

Think about increased brand advertising as an example that would result in understated earnings. (Under GAAP, intangible growth-producing activities are immediately expensed. For example, money spent on research and development or advertising, which pay off over time, is written off in the year incurred. Investors need to tackle such distortions.)

To make matters worse, GAAP offers flexibility in deciding whether certain operating costs are capitalized or expensed. Capitalizing the costs means that those costs will not appear in the income statement thus will not drag down the earnings of the current period. Instead, they will show up on the asset side of the balance sheet under some fancy name and will be amortized over time.

AOL made the most of this when they capitalized their direct-response advertising costs (that were part of their normal operations) in order to overstate earnings. To add insult to injury, once that fictitious asset grew so big on the balance sheet that even its amortization expense was hurting the manipulated earnings too much, management decided to double the amortization period of these exploding marketing costs meaning that they essentially cut the annual drag on earnings in half.

This simple accounting adjustment helped hide AOL’s huge losses from investors. (If you still believe that reported earnings can be trusted with your eyes closed, I highly recommend reading the book Financial Shenanigans by Howard Schilit.)

Courtesy of FAST Graphs, I can show you Amazon’s example where the earnings per share figures seemed to have absolutely no relationship with the stock price between 2005 and 2016. While the price rose from $40 to $660, EPS fluctuated wildly in the -$0.5-$2.5 range. Wherever earnings go, the price is not that sure to follow. 

There’s a logical explanation, and we’ll get there in a minute!

…but we still have cash flow!

“Earnings can lie, but cash flow cannot,” you may say. Unfortunately, I’ve seen too much to agree. While turning our attention to the cash-generating capability of the business is a great way to tackle most of the accounting distortions or outright manipulation, you have to accept that even the cash flow numbers can be fudged. Let me show you how!

(And then we turn to a possible solution as well, so hold on a little more… Understanding these concepts is absolutely necessary for you to become a better investor.)

So… Managers know that sensible investors are trying to estimate the sustainable level of cash flow that the company is able to produce, as only this can be the basis of a sound valuation. The cash flow statement is made up of three parts: operating, investing, and financing sections.

Of these three, cash flow from operating activities is the only one that is deemed sustainable since, unlike the cash provided by investing or financing activities, operating cash flow comes from a renewable source, operations.

It’s no surprise that managers want to classify as much of the cash flow as operating as legally possible, even if that classification may not match the economic realities of the business.

Again, GAAP provides ample room for playing with certain items. (You can find dozens of tricks in the book Creative Cash Flow Reporting by Charles W. Mulford.)

Looking at Amazon’s free cash flow (that is, operating cash flow minus capital expenditure) still doesn’t seem to explain the continuous upward momentum of the stock price. Looking at the green area showing free cash flow, all you see is bumpiness while the stock price was relentlessly moving up.

We need a much better explanation, a much closer relationship with the stock’s performance. Cash flow is just not good enough!

Let me tell you about EVA…

Fortunately, there’s a category called EVA (Economic Value Added) that exhibits the exact characteristics we seek as thoughtful investors:

You may notice that the compound annual growth rate (CAGR) of EVA is very close to the total annualized rate of return Amazon provided in the examined period. (26.5% vs. 28.5%, if you don’t want to scroll up to check the numbers.)

This is not a pure coincidence, as data shows. (Read my whole article about how the EVA framework can give you an edge as a value investor here!)

EVA shows the true value creation by addressing accounting distortions one by one, so this is the metric I opt for when it comes to analyzing a company from a business owner’s perspective.

Do not follow the herd: Most valuation multiples are plain wrong!

Listen closely, because this can be a game changer for you

Everything you have just read comes down to a very important finding: the most widely-used valuation multiples can fool you (and other investors).

You’re not alone; most investors use multiples when it comes to assessing a stock’s valuation. The classic line of thought goes something like this: “Whirlpool (WHR) is trading at a PE of 6 while the typical range for this stock has been between 11 and 14 in the last five years, so the stock looks cheap.”

(The dark green area shows Whirlpool’s earnings per share. The black line is the stock price. The blue and orange lines mark the “fair value” range in which the stock price tends to fluctuate. As the price is below that range, Whirlpool looks undervalued based on the fundamentals displayed above.)

“If the sentiment turns, and the PE multiple climbs back to 11, I could get a very attractive annualized rate of return.”

Based on analysts’ estimates on Whirlpool’s earnings per share and the assumption that the valuation multiple will climb back to its “standard level,” to the blue line, you could simulate a scenario in which your investment’s annualized total return could reach almost 50% on a ~20-month timeframe.

Let’s see what could go WRONG…

First, which multiple would you pick?

Is the most popular price-to-earnings (P/E) your multiple of choice with EPS in the denominator? 

If so, you must be rooting for an increase in the company’s earnings-per-share so that this higher EPS, multiplied by your target PE ratio (that you wish the stock would climb back to), would give a higher share price, thus a higher return on your investment.

The problem is that EPS is the earnings that accountants calculate, and accounting has serious flaws. In fact, EPS can increase if all earnings are retained and simply invested at a non-zero rate. Does this make the company more valuable? Are you really satisfied with any non-zero return on that retained money that belongs to you?

To take this further, any investment financed with debt, such as a major acquisition, will contribute to accounting net income, increase earnings per share (EPS), and elevate the firm’s reported return on equity (ROE) so long as it generates a rate of return that is anything over the after-tax cost of the borrowed funds, that can be near zero these days.

Even Warren Buffett made this point in his 2017 letter to Berkshire shareholders: “The ample availability of extraordinarily cheap debt in 2017 further fueled purchase activity. After all, even a high-priced deal will usually boost per-share earnings if it is debt-financed. At Berkshire, in contrast, we evaluate acquisitions on an all-equity basis.”

Any firm can show positive net income and EPS along with EPS growth as long as it is covering the after-tax cost of the money it borrows. In accounting, stockholders’ equity is considered free. As long as you have any return expectation when you invest in stocks, you must disagree with the Generally Accepted Accounting Principles (GAAP), and you most certainly need to address this issue when making investment decisions.

Using the PE, as I did for illustration purposes in the example above, ignores this huge shortcoming. EPS says nothing about the true value creation of companies; thus, any multiple based on EPS should be used very carefully, if at all.

That said, the price (P) part of the ratio has its flaws as well. See Joel Greenblatt’s example below (from his book The Little Book That Still Beats the Market):

While A and B are the exact same companies, the difference in their capital structures distorts the PE (and all capitalization-based multiples, for that matter). Have you ever thought about this when mechanically applying your PE targets in a tool like FAST Graphs?

Sure, multiples using Enterprise Value (EV) instead of price address this problem, but as soon as you pick EBIT, EBITDA, or Free Cash Flow as the second part of your EV-based ratio, you may be in for some trouble.

Enterprise value equals the value of the stock’s debt and equity capital, given its share price, net of excess cash, and assuming that the book value of liabilities approximates their market value. Simply put, EV = market cap + total debt – surplus cash.

If cash is king… what about a free cash flow multiple?

Free Cash Flow (FCF) can be calculated by deducting capital expenditures from the operating cash flow. Basically, FCF is the amount of cash that remains after everything has been paid, all new investments have been made, and is available for distribution to the shareholders. The key question goes: Is more free cash flow always better? Not really!

A large amount of free cash flow may indicate that the company can’t find sufficient opportunities for new investments, which can limit future growth prospects. Negative free cash flow, on the other hand, could indicate that the company has an abundance of investment opportunities but not enough internal cash flow to pursue all of them.

In fact, FCF in any one year, or even over longer intervals, is not a reliable measure of performance. You saw this in Amazon’s example, right?

The key question is whether the company is investing in positive NPV (Net Present Value) projects that have attractive returns above the cost of capital. If yes, the more investments it makes, and the lower or more negative its free cash flow goes, the greater value is created (that will be reflected in the stock price).

It is simply not possible to tell whether a firm is more or less valuable by generating more or less free cash over a period of time, so there go the P/FCF and EV/FCF multiples out of the window.

That said, when I studied at Columbia Business School’s Value Investing and Advanced Value Investing courses, they advocated using EV/FCF and EV/EBIT as valuation multiples. Knowing what I know now, I’m not that fond of either. I’ll show you in a minute what my preferred metrics are and how I use them.

If you wish to devote some time to killing all the popular multiples containing EBIT, EBITDA, or book value, you may want to read the book Best-Practice EVA by Bennett Stewart. Not an easy read, but you can find examples there that illustrate how continuing growth in sales, EPS, EBIT, and EBITDA can be produced without any increase in shareholder wealth.

And here comes EVA (Economic Value Added) to the rescue

In simple terms, EVA is a metric that measures the firm’s profit remaining after deducting all costs (adjusted for accounting distortions), including the cost of giving the firm’s investors a full, fair, and competitive return on their investment in the business. EVA is a comprehensive net profit score that charges for all capital used, including shareholders’ equity, which is falsely considered free money under GAAP accounting.

EVA is far superior to EPS or Free Cash Flow; in fact, charging for all capital makes EVA the most demanding profit performance measure and the number-one choice for investors with a long-term business owner mentality. (Read my article on EVA for more details.)

Although Warren Buffett has never used the trademarked term EVA (Economic Value Added) in his letters, he keeps emphasizing the importance of the “money’s-not-free approach.”

(In fact, he uses this “money’s-not-free approach” term in his 1994 letter when he writes about the compensation plan at Scott Fetzer. Under the plan, the CEO’s bonus increases when earnings on additional capital exceed a meaningful hurdle charge and decreases if incremental investment yields sub-standard returns. Equity is not free money. Retained earnings must earn their keep!)

“Indeed, in both 2015 and 2016 Berkshire ranked first among American businesses in the dollar volume of earnings retained, in each year reinvesting many billions of dollars more than did the runner-up. Those reinvested dollars must earn their keep.” (Warren Buffett in his 2016 letter to Berkshire shareholders)

“Unrestricted earnings should be retained only when there is a reasonable prospect – backed preferably by historical evidence or, when appropriate, by a thoughtful analysis of the future – that for every dollar retained by the corporation, at least one dollar of market value will be created for owners. This will happen only if the capital retained produces incremental earnings equal to, or above, those generally available to investors.” (Warren Buffett in his 1984 letter to Berkshire shareholders)

As you can see, one of the greatest investors of all time does think that the accounting distortion of “free equity” must be addressed. Here is where EVA (Economic Value Added) enters the field. In simple terms, EVA is sales less operating costs (adjusted for distortions) less the full cost of financing business assets as if the assets had been rented.

As Bennett Stewart writes in Best-Practice EVA: “The cost of capital is not a cash cost you can see and touch. It is not a cost that accountants actually deduct or ever will. It is an opportunity cost— the cost to the lenders and shareholders of giving up the returns they could otherwise expect to earn from investing their money in a stock and bond portfolio that has a risk profile the same as the company in question.”

In the EVA framework, the company is earning a positive economic profit only after covering all resource costs, something that is true of only about half of the public companies in the economy at any time. (Read it again: it is not at all evident that companies are earning adequate returns on the capital they employ. More companies are profitable in the accounting sense than those who can outearn their true cost of capital, with the equity portion included.)

Take a look at Whirlpool between 2013 and 2019!

As you see, earnings per share shows a nice increase almost every year between 2013 and 2019 (from $10 to $16), yet the stock price (the black line) is moving sideways. EVA shows you the reason:

While EPS exhibited growth, the increase in EVA (real value creation) was not that clear, to say the least. This is a classic example of where EVA and EPS differ, and EVA wins the argument.

In fact, a stock is worth more only if:

(1) the underlying company is creating more value, meaning that the current EVA increases, or

(2) investors’ expectations about the firm’s future EVA creation increase.

Simply put: the drivers of shareholder returns are earning and increasing EVA and increasing expectations for earning even more EVA.

Are you still with me? Let’s dive in once more…

As expectations about future value creation are a driver of the stock’s valuation, it’s time to dissect the components of value in the EVA framework so that we can see what expectations are reflected in the current stock prices.

Remember: EVA is the real value the business created for its investors. The more the EVA the better the performance. In contrast to earnings or cash flow, EVA takes the distortions of GAAP accounting into account. (Read more about EVA in this article.)

For quantifying the expectations for future growth in EVA, we can use the so-called Future Growth Reliance ratio. I deliberately simplify here just to get the point through as easily as possible. (If you want all the details, read the Best-Practice EVA book.)

A firm’s market value consists of the following components:

  • Capital: That includes all capital invested in the business, including working capital, net property, plant, and equipment, the present value of rents, intangible capital, and several capital adjustments.
  • Current Value Added (CVA): The value derived from capitalizing current level EVA at the cost of capital in perpetuity. In practice, this is trailing 4-quarter EVA divided by the cost of capital (i.e., a zero-growth EVA perpetuity). This comes from assuming that the firm’s EVA remains constant forever.
  • Future Value Added (FVA): The present value of the expected growth or decline in EVA. When a stock has negative FVA, investors expect EVA to decline from its current level and vice versa.

Below you can see how these components make up the Market Value, and how we can get from this enterprise level metric to the market cap. (MVA stands for Market Value Added and is the sum of CVA and FVA. MVA essentially measures how much more the company is worth than the capital that has been put in.)

There is a way to derive FVA from share prices. This implied FVA measures the total present value of the growth in EVA that investors are implicitly forecasting. Future Growth Reliance (FGR) is the ratio of FVA to market value. It is the percent proportion of the firm’s market value that is derived from, and depends on, growth in EVA.

For example, the FGR ratio of 20% says that the firm’s market value would tumble 20% if investors became convinced that it would never be able to increase EVA above its current level. A negative FGR ratio signals that the market is discounting the stock’s current level of EVA, indicating an expectation for future headwinds.

To sum up, a higher FGR ratio indicates higher valuation. We want to buy our top-quality stock targets (EVA Monsters) when this sentiment indicator is low.

As complicated as the above paragraphs may sound, in practice, we are looking at charts like this and have formulas to compare the stock’s current FGR-based valuation to its long-term mean and median.

In T. Rowe’s example above, the market essentially prices in that the firm’s EVA will shrink considerably going forward. That may signal an opportunity as long as you have a differing opinion based on your fundamental analysis.

No indicator is perfect… Here’s my solution!

Using one single metric in a vacuum usually proves to be a serious and costly mistake. To address this issue, at the FALCON Method, we are looking at companies from many different angles to come up with a proper assessment on their current valuation.

(Read about our 7-step stock selection process HERE!)

Besides FGR (shown above), we employ two distortion-free multiples (EV/EBITDAR and MV/NOPAT). Here’s a little explanation:

EV and MV are essentially the same; they stand for enterprise value and market value, respectively.

As written above, EV or MV equals: market cap + total debt – surplus cash. By using this category, differences in capital structure will not distort our assessment, as you’ve learned from Joel Greenblatt’s example.

NOPAT: After corrective adjustments to remedy accounting distortions, NOPAT measures the free cash flow from operations that is distributable after ensuring that tangible and intangible assets needed to sustain the profit can be replenished. This is a much better version of free cash flow than you could calculate on your own by simply deducting all capital expenditures from the operating cash flow.

The EVA guys are great at addressing distortions and tackling nuances; you have to give them credit for that!

EBITDAR is an improved version of the widely used EBITDA metric as it includes add-backs like rent expenses, R&D, and advertising spending. Both the NOPAT and EBITDAR multiples are useful and highly-enhanced versions of the commonly used valuation multiples.

Here’s a short sample from a previous FALCON Method newsletter to show you how we use these metrics. Omnicom’s numbers are presented here for illustration purposes only. (The column 3yr marks the 3-year average, etc.)

The lower these numbers, the more pessimistic the valuation. (This holds true for all three metrics.)

To make it clear, these are rather sentiment indicators than tools for explicitly calculating a stock’s fair value. (We are approaching that question in a different way, but that’s a story for another day.) These ratios can be compared to peers, industry benchmarks, and the stock’s own history.

All things equal, we want to buy our top-quality targets when the baked-in expectations are low since that is when surprising on the upside has the highest probability. As investment is a game of probabilities, all we can do is stack the odds in our favor as much as possible; this is why we are using institutional-level data.

Value investing is dead… Long live value investing!

I hope that I managed to live up to the promise that this article would teach you more than CNBC could in a decade.

As for the value vs. growth debate, I’ll let Warren Buffett point out why it doesn’t make sense: “The two approaches are joined at the hip: Growth is always a component in the calculation of value.” But not all growth should be considered equal!

As the EVA concept highlights, only that type of growth creates shareholder value where the company earns a higher return on its growth projects than the true cost of the capital needed to finance those projects. All else classifies as value-destructive growth; and you’ll want to steer clear of those companies where management’s empire-building ambitions take priority over creating shareholder value.

Your key takeaway is this:

Sensible stock investing is way too complex to qualify as a hobby or a part-time job. This is a profession!

At the FALCON Method, we are not “playing the stock market” but make thoughtful investment decisions supported by our evidence-based stock selection process. The difference between the two approaches is night and day!

The relevant metrics of business valuation may have evolved as decades went by, but as Berkshire Hathaway’s vice chairman Charlie Munger told at the company’s 2007 annual meeting:

“There is no one easy method that could be simply mechanically applied by, say, a computer and make anybody who could punch the buttons rich. By definition, [investing] is going to be a game which you play with multiple techniques and multiple models, and a lot of experience is very helpful.”

I couldn’t agree more.

The FALCON Method newsletter service is there to support your investment decisions for a fraction of the fee we pay for the institutional-level data, so you get the work of our experienced analyst team as a bonus.

Ready to take the guesswork out of investing and get to the next level?

Learn more about how the FALCON Team uses these data to find the best stocks.

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