Reproducing Summary of the Michael J. Mauboussin PE paper (referred earlier)
Here are some conclusions from this discussion:
1.Multiples are not valuation; they are shorthand for the process of valuation. The value of a financial asset is the present value of future cash flows. Accordingly, it is essential to understand the components of a multiple and to have a sense of what those components imply about a company’s future financial performance.
2.In assessing capital allocation, consider incremental returns on capital first and growth second. Growth only creates value if the investments generate a return in excess of the cost of capital. Note that this return need not be immediate. But no company should pursue growth solely for the sake of growth, and the research shows that rapid asset growth is correlated with weak shareholder returns.
3.Compare companies based on their business models, not their line of business. For companies to be truly comparable, they must have similar outlooks for incremental returns, growth, and investment
_opportunities. They must also be financed in a similar fashion for a price-earnings multiple to be useful. _
4.Be very careful using the past to understand the future. Past multiples are only relevant to the degree to which the underlying drivers of value are consistent through time. In fact, many of these drivers have changed, greatly diminishing the utility of past averages.
5.This discussion applies to all multiples. While we limited our comments to price-earnings multiples, the basic concepts apply to any multiple. The most commonly used multiples after price-earnings are
enterprise value-EBITDA (EBITDA stands for earnings before interest, taxes, depreciation, and
amortization) and price-to-book value.
6.Be mindful of the quality of earnings. We delved into our discussion using techniques and definitions (e.g., net operating profit after tax, investments, and cost of capital) that come from a discounted cash flow (DCF) model. The goal of a good DCF model is to avoid accounting vagaries and to zero in on the cash flow. Earnings fail to do this, and managements have a great deal of discretion in determining the earnings they report. As Alfred Rappaport’s quotation at the beginning of this report reminds us, “cash is a fact, profit is an opinion.”