Finding the Right P/E Multiple – Or How to Handicap a Stock

First, a huge warning about the tables I’ll be showing you in this memo. The P/E multiples shown here are useful as a theoretical tool for getting some idea of how important durability – being able to know a stock will still be turning an annual profit more than 5 years from now – and growth (being able to know a stock will compound intrinsic value faster than the overall market) is in finding the right P/E for a stock.

Basically, what I’m saying here is that if literally all you know about a business is that it will grow 5% a year for the next 5 years (and then you don’t even know if it will lose money or not in year six) – you can’t afford to pay anything but an incredibly low P/E for that stock. Likewise, to justify a P/E ratio of 30 or 100 or some number as unusually high as that – you will need to be able to project a stock will not just compound intrinsic value quickly – but that it will continue to compound at above market rates for 15 to 20 years (not just 5 to 10).

As you read this memo, remember those two principles. And remember this is not a magic formula table that tells you – based on past figures – whether a stock is mispriced or not. It’s a thinking tool that tells you if you really are unusually certain about a stock’s long-term compound future, just how much that certainty should change the P/E you’re willing to pay.

For example, it tells you that you really can pay an absurdly high P/E ratio for a stock you are 100% certain will compound value faster than the S&P 500 – if and only if you know that compounding will last for 15-20 years. Knowing that above average growth will last for 5 years isn’t enough.

Now, to today’s question:

“Would be keen to get your thoughts on how you think about what multiple a stock should trade on and also how you appraise a stock’s value. I think multiple is a function of a number of things – earnings growth, durability, industry evolution, reinvestment and earnings retention etc. – but very keen to hear how you think of it. It’s something that I find difficult, particularly for higher quality businesses that are already on high multiples.”

The formula that really matters in investing is simply:

Compounding Power / Price

If you take “compounding power” and you divide by “price” – you should always know which investment to make. If two stocks have the same price, you should always buy the stock that compounds better. And, if two stocks are equal compounders, you should always buy the cheaper stock.

Warren Buffett’s business partner, Charlie Munger, has said:

“To us, investing is the equivalent of going out and betting against the pari-mutuel system. We look for a horse with one chance in two of winning, and that pays …

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Over the Last 17 Years: Have My Sell Decisions Really Added Anything?

I get a lot of emails from people saying that my strategy has changed – I’ve become more of a growth investor and less of a value investor – over time.

 

It’s true that the investments I’ve made in recent years have definitely changed.

 

But, my philosophy has changed less than it would appear from my stock picks. I concentrate heavily and go where I see opportunities I consider “nearly certain” rather than being the highest return opportunities based on pure probabilities.

 

There is, however, one area where my philosophy really has changed:

 

I’m convinced that I should simply hold stocks indefinitely.

 

Why?

 

Let’s start with two spin-offs I bought. One spin-off happened 2 years ago. The other spin-off happened a little over 10 years ago.

 

First, the 2-year-old spin-off. I have 25% of my portfolio in BWX Technologies (BWXT). I bought that as part of a spin-off from Babcock & Wilcox. The stock has returned more than 30% a year in the two years since the spin-off. It now trades at a P/E of 26. Normally, this is when a value investor would sell the stock. However, I think the company can grow earnings per share by 10% a year for the next several years. I also think a company of this quality should always trade at a P/E no less than 25. So, with no new ideas that seem more likely to deliver returns of 10% a year or better – I have no intention of selling BWXT. With the catalyst from the spin-off gone and the P/E above 25 – no value investor would keep holding this stock. But I intend to. Does that mean I’m not a value investor?

 

It might mean that. But, it also may just mean I learned from the last spin-off I liked a lot.

 

About ten years ago, I picked a spin-off called Hanesbrands (HBI). Here’s a quote from a roundtable discussion I did back in 2006 (share prices are not adjusted for subsequent splits):

 

“However, there are many situations (and here is usually where you find some bargains) where the EV/EBIT measure is not the most useful. When I can predict a high free cash flow margin with confidence, I use a very long-term discounted cash flows calculation. For instance, this is what I would do with Hanes Brands which was recently spun-off from Sara Lee. On an EV/EBIT basis, it may not look cheap. But, looking truly long-term, I’m convinced the intrinsic value of each share is much closer to the $45 – $65 range than the roughly $23 a share at which it now trades. But, that’s a special case – Hanes is a special business.”

 

I gave that quote back in October of 2006. Hanesbrands stock has compounded at 12% a year in the 10 years since I made that comment (it’s compounded at 15% a year since the actual spin-off date).

 …

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Reflections on the Newsletter: Why Quan and Geoff Wrote Those 27 Stock Reports

Focused Compounding includes a “Library” with 27 stock reports. I co-wrote those stock reports with Quan Hoang between 2013 and 2016. Although Quan and I no longer work together, he agreed to put his thoughts on that experience in writing for our community members to read. I think reading Quan’s “Reflections” will help you put each of those 27 reports in better context.

 

Quan’s Reflections

Geoff asked me to write a reflection on my experience writing The Avid Hog (a newsletter we later renamed Singular Diligence). So in this post, I’ll share my experience and show why I believe stronger than ever that long-term investing is the best path to wealth.

Geoff and I started our venture in 2012. Initially we had been hired to start the research arm for a financial company. Right after my college graduation, I flew to Plano and was eager to work in person with him, who to me is like Ben Graham (or Phil Fisher) to Warren Buffett. However, due to some disagreement with our employer over the product we were developing, Geoff decided to quit. That night by a pond near both our apartments, Geoff told me that he was about to turn 28 and he did not like doing the job that he didn’t like just to find several years later too late to switch. He asked if I wanted to quit and partner with him. That was exactly my plan when I knew he quit because learning from him was the only reason I went to Plano.

So we start our venture without a clear direction. We just wanted to write a newsletter. I imagined that would be the best learning process for me. I would do in-depth research every day and my knowledge would compound. If I did a good job, the newsletter would bring in cash flow for me to invest and I could be financially independent. Even if the newsletter did not make money, I would still learn a lot. I was young and determined to become a great investor. I didn’t see any job that could truly train me as an investor (and I still don’t see today.) That’s also the reason why there are so few good investors. Most students are obsessed with getting a job. Investment banks would train you to be a next-quarter forecaster, not an investor. Most investment funds don’t have the right investment framework and spend most of their time watching the wrong kind of information. In general, once one gets a job (finance-related or not), he will enter a rat race, leaving them no time to seriously practice value investing. I didn’t like that path. I was young and I was willing to invest my time.

From that day on, I would go to Geoff’s apartment each day. We started by writing blog posts regularly to connect with our audience. That was the bad part of each day. I don’t like writing and I always struggle to find ideas …

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Geoff’s Mental Model #1: “Market Power”

“The single most important decision in evaluating a business is pricing power. If you’ve got the power to raise prices without losing business to a competitor, you’ve got a very good business. And if you have to have a prayer session before raising the price by 10 percent, then you’ve got a terrible business.”

– Warren Buffett

A business with market power is a good business. A business without market power is a bad business. In that quote, Buffett gives a clear definition of market power when he says: “if you’ve got the power to raise prices without losing business to a competitor” you’ve got a very good business. Basically, if you’ve got the power to raise prices without losing business to a competitor, you’ve got market power.

Market power is not an internal advantage. It is not a technological advantage, a better corporate culture, or a process improvement your competitors have yet to figure out. Market power is external. It is a strong bargaining position versus those folks a company must sit across the negotiating table from.

Market power is the ability to make demands on customers and suppliers free from the fear that those customers and suppliers can credibly threaten to end their relationship with you.

Market power is often misunderstood as being an advantage one competitor has over another. That’s the wrong way of thinking about it. Businesses don’t squeeze profits from competitors. Businesses squeeze profits from customers and suppliers.

Often, competitors engage in rivalry that undermines each other’s bargaining position with customers and suppliers. In such industries, customers can play one competitor off against another. By doing this, they can negotiate for higher product quality, lower prices, longer payment terms, etc.

However, there are industries free from that kind of rivalry.

As investors, those are the industries we want to focus on. The best businesses in the world are in the best industries in the world. And the best industries in the world are those where the rivalry between competitors does not undermine the market power these businesses have over their customers and suppliers.

 

Dependency: Mini-Monopoly

All publishers have a mini-monopoly over each title they publish.

In children’s books, if you’re a bookstore that wants to carry Harry Potter – you have to pay Scholastic (SCHL) whatever Scholastic wants to charge for that title. Scholastic is your sole source of Harry Potter books. The only power you have in the market for Harry Potter books is to either accept or decline a take-it-or-leave-it offer from one seller. There are no competing offers you can consider.

In videogames, if you’re a gamer who wants to play World of Warcraft – you have to pay Activision-Blizzard (ATVI) whatever monthly fee Activision wants to charge for that MMORPG. Blizzard is the sole source for your WoW fix. The only power you have in the market for World of Warcraft access is to either accept or decline a take-it-or-leave-it-offer from one seller. Those who decline the …

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EBITDA and Gross Profits: Learn to Move Up the Income Statement

“In lieu of (earnings per share), Malone emphasized cash flow…and in the process, invented a new vocabulary…EBITDA in particular was a radically new concept, going further up the income statement than anyone had gone before to arrive at a pure definition of the cash generating ability of a business…”

• William Thorndike, “The Outsiders”

 

“I think that, every time you (see) the word EBITDA you should substitute the word bullshit earnings.”

• Charlie Munger

 

The acronym “EBITDA” stands for Earnings Before Interest, Taxes, Depreciation, and Amortization.

A company’s EPS (which is just net income divided by shares outstanding) is often referred to as its “bottom line”. Technically, EPS is not the bottom line. Comprehensive income is the bottom line. This may sound like a quibble on my part. But, let’s stop and think about it a second.

If EBITDA is “bullshit earnings” because it is earnings before:

• Interest
• Taxes
• Depreciation and
• Amortization

Then shouldn’t we call EPS “bullshit earnings”, because it is earnings before:

• unrealized gains and losses on available for sale securities
• unrealized currency gains and losses
• and changes in the pension plan?

I think we should. I think both EBITDA and EPS are “bullshit earnings” when they are the only numbers reported to shareholders.

Of course, EPS and EBITDA are literally never the only numbers reported to shareholders. There is an entire income statement full of figures shown to investors each year.

Profit figures further down the income statement are always more complete – and therefore less “bullshit” – than profit figures further up the income statement.

So:

• EBITDA is always less bullshit than gross profit.
• EBIT is always less bullshit than EBITDA.
• EPS is always less bullshit than EBIT.
• And comprehensive income is always less bullshit than EPS.

Maybe this is why Warren Buffett uses Berkshire’s change in per share book value (which is basically comprehensive income per share) in place of Berkshire’s EPS (which is basically net income per share). Buffett wants to report the least bullshit – most complete – profit figure possible.

So, if profit figures further down the income statement are always more complete figures, why would an investor ever focus on a profit figure higher up the income statement (like EBITDA) instead of a profit figure further down the income statement (like net income)?

 

Senseless “Scatter”

At most companies, items further up the income statement are more stable than items further down the income statement.

I’ll use the results at Grainger (GWW) from 1991 through 2014 to illustrate this point. The measure of stability I am going to use is the “coefficient of variation” which is sometimes also called the “relative standard deviation” of each series. It’s just a measure of how scattered a group of points are around the central tendency of that group. Imagine one of those human shaped targets at a police precinct shooting range. A bullet hole that’s dead center in the chest would rate a 0.01. A bullet hole that …

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