5.7. Ignoring Valuation
Lesson objective
Understand the risk created by expectations.
An excellent company may produce a disappointing investment return if the price already assumes results that are difficult to exceed. When the multiple is high, small disappointments can cause large price declines.
A cheap company is not automatically attractive either. The market may be anticipating real deterioration.
Evaluate scenarios, historical multiples, peers, and cash-flow yields.
A great company can still be a poor purchase at the wrong price
Valuation links the quality of a business to the expectations already embedded in the market price.
Common starting points:
P/E = Share Price ÷ EPS
FCF Yield = Free Cash Flow ÷ Market Capitalization
EV / EBITDA = Enterprise Value ÷ EBITDA
A multiple is a compressed expectation
Higher multiples can be justified by faster growth, stronger margins, lower risk, better returns on capital, or greater durability. But the higher the expectations, the less room exists for disappointment.
Why paying 40× earnings changes the question
At 40× earnings, the earnings yield is roughly 2.5% before considering growth: 1 ÷ 40 = 2.5%. Investors may still earn attractive returns if earnings grow strongly for a long time, but that growth is doing a large part of the valuation work. If growth disappoints, both earnings expectations and the multiple can fall.
Do not ask only, “Is this business excellent?” Also ask, “What performance does today's price require for my return to be satisfactory?”
What you should remember
- Business quality and valuation should be analyzed separately.
Practice
Compare a company's current multiple with its history and write what expectations appear embedded in the price.