When I meet with company managements, it usually becomes quickly evident how vast the gulf is between how the talking heads on CNBC speak…and what I would call business “generalists”; i.e., everybody else. When discussing a firm’s probable valuation, I’ll sometimes refer to sector valuations in the public marketplace. When I witness blank responses, I realize I need to back up.
I spent 30 years on Wall Street and recognize the utility of many valuation tools, however confusing it may be to the layman. After all, a company’s valuation (a stock) may seem unexceptional across many methods. But it only takes the right one to reveal what is overpriced or undervalued. As such, I’d like to offer some thoughts on my experience with valuation metrics.
The more common valuations techniques include:
- Price to Book (P/B)
- Price to Earnings (P/E)
- P/E to Earnings Growth (PEG)
- Enterprise Value to EBITDA (EV/EBITDA)
- Price to Sales
- Price to Sales Growth
In my experience, we didn’t use the Price to Book metric much unless a company was a bank or owns valuable assets like mining rights or real estate. This is because cost accounting methodology produces inaccurate (outdated) asset values, doesn’t consider intangibles well, and is often distorted by one-off write-downs. (However, when a company hit severe financial straits and was in a freefall, we would use price to book to gauge where a declining stock might show some stability.)
Instead, when I began as an analyst in the 1980s, it was all about P/E comparisons. Then, the growth years of the 1990s came, and the market needed a way to compare companies with different growth rates. Hence, “PEG” (p/e to growth) gained currency. In this method, we divide the P/E is by a firm’s anticipated growth rate. So, a company with a 10x P/E and a 15% growth rate (0.67x PEG) would be more attractive (cheaper for a buyer) than a firm with a 10x P/E and a 5% growth rate (2x PEG).
Later, investors wanted valuation metrics that accounted for different financial structures as well as cash flow. As a result, “Enterprise Value to EBITDA” became a staple on our valuation tables. Enterprise value is simply the sum of a firm’s equity value and its outstanding LT debt.
EBITDA (earnings before interest, taxes, depreciation, amortization) is an easily calculable proxy for cash flow. It excludes the often distortive line items of interest, taxes, and D&A. Why did this become more important? Mergers and acquisitions (M&A) were rising. A company’s potential to be acquired became a more significant part of stock market psychology, and investors increasingly viewed through those lenses. Large companies that are sifting through acquisition opportunities are less interested in the interest, tax, and D/A line items because (1) they have their own capital structures and tax rates which will supersede the target’s, and (2) asset values are usually “re-assessed” in purchase accounting methodology (resulting in new depreciation schedules).
Next, as we all aware, the world changed with the advent of the internet, Amazon, etc. Being aware of this massive change but unsure of the ultimate winners and losers, investors began to focus on topline success disproportionately. Investors were less concerned about gross margin and expense fluctuations-as long as the topline results were evidence of successful market disruption and share gains. Management teams who gave traditional attention to managing margins and expenses were actually penalized for “missing the big picture,” i.e., being too inwardly focused while losing out on major market opportunities. Hence, the valuation metric focusing on sales (Price to Sales) gained prominence.
As with earnings, there had to be a way to adjust for the relative differences in sales growth among companies when assessing investment opportunities. The companies that could demonstrate market share gains through faster sales growth were accorded higher valuations. The Price to Sales Growth method gained prominence as a result.
Importantly, individual sectors have their own valuations measures tied to a vertical’s particular operating metrics. But that’s for another day.