Quality compounders

Valuations need to tell the whole story

While the price to earnings (P/E) ratio is a popular and commonly used metric in equity valuation, we firmly believe that a healthy dose of caution is required.

23 Apr 2024

3 minutes

Quality Team

“Follow the money” is a phrase that entered the common lexicon following the 1976 film ‘All the President’s Men’. Beyond helping crack the Watergate scandal, it’s also sound investment advice. While the price to earnings (P/E) ratio is a popular and commonly used metric in equity valuation, we firmly believe that a healthy dose of caution is required. For us, free cash flow and enterprise value-based measures paint a far fuller picture.

We believe that the P/E ratio as a valuation measure is a blunt tool:

  • The metric takes no account of how much debt a company holds and, therefore, how risky its balance sheet is. As a result, it unfairly penalises unlevered businesses.
  • The earnings figure is based on accrual accounting, which can be influenced by a variety of factors that obscure the underlying operating performance of the business.
  • No account is made of the quality of those earnings, and whether they represent a high or a low return on the capital invested in the business.

Make accurate comparisons

Other measures, such as enterprise value to operating profit and free cash flow (FCF) yield, better determine whether a stock is expensive or cheap. The enterprise value includes the net debt, as well as the market capitalisation of a company. It therefore accounts for the use of leverage and is more reliable when comparing companies with different corporate structures and different accounting or tax regimes. This is critical in a cross-border and global investment environment.

Enterprise value

Source: Ninety One. For illustrative purposes only.

The FCF yield accounts for the price paid for a stock relative to the level of free cash the company generates (its operating cashflow minus capital expenditure). FCF yield captures the actual tangible cash-generating power of the business. It also better reflects the available cash that can be used to reinvest in the business for growth, or to service debt, or be returned to investors through dividends and share repurchases.

FCF yield

Source: Ninety One. For illustrative purposes only. EBIT = Earnings Before Interest and Taxes. NOPAT = Net Operating Profit After Tax.

Overall, an active approach is key, ensuring valuation methodologies used are appropriate and consistently applied, and crucially that valuations are put into context. Such context includes, for example: longer-term history; valuations of competitors, the wider equity market and other asset classes; a company’s stage in the cycle; and the quality, growth and risk characteristics being paid for. If one business is of far higher quality, exhibiting a consistently high return on invested capital (ROIC), with defensible market positions in an attractive, growing market, investors should be willing to pay a differentiated valuation versus a structurally challenged, commoditised, ex-growth or overly cyclical business.

Use an Internal Rate of Return

Use an Internal Rate of Return

Source: Ninety One. For illustrative purposes only.

We believe the most robust way to value companies is to use an internal rate of return (IRR) calculation. This is the rate at which modelled FCF forecasts are discounted to deliver a net present value of zero at current share prices – in effect, the expected return given starting valuations and forecasts of future cash flows. The advantages of this figure are that it is forward looking, it is cash flow based, it includes longer term as well as short term cash flow forecasts, it captures the time value of money, and it is a simple and directly comparable metric that is calculated bottom-up based on our own individual company models using a common set of assumptions.

It is this, above all else, that enables us to find quality compounders.

Authored by

Quality Team

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