Study: An Overlooked Fact about Valuations
Factors Driving Prices
To simplify, there are 3 factors driving a stock’s price:
Change in quantum of earnings
Change in earnings multiple
Change in shares outstanding
One of the things that is often overlooked in the stock market is how valuable it is to have a low valuation.
If a company is self funding (it doesn’t need to rely on a high stock price as currency to raise fresh funds), then a low valuation is a blessing, not a curse.
So if a company initially had low earnings multiple but experiences a rise in their multiple due to high current/future growth, this is actually not beneficial to long-term owners.
Of course, a stock that goes from 10x to 20x earnings over a decade has a nice 7% annual tailwind from that multiple expansion. But what many management teams often forget is that low multiples can create more value over the long run than a one-time bump in multiples.
Why Persistent Low Multiples is good for Intrinsic Value growth?
Answer: Low multiples allow management to repurchase shares at a discount!
It is obvious that a cheap stock which persists for many years gives the company the ability to consistently buy back shares at a high earnings yield.
Imagine a stock that averaged PE of 12x for a long period of time, it is going to create far more long term value than if this same company traded at PE of 30x, because the market’s lower valuation allows the company to reduce far more shares at 12x versus 30x.
For example, Apple in 2016 with PE of 12x was going to create enormous value given that their free cashflows was allocated to repurchase shares. The earnings growth was at a modest rate of 8%.
Let’s suppose Apple’s PE does not change, the intrinsic growth rate per share would have been 16% assuming growth requires no retained earnings (buyback yield 8% + earnings growth 8%). Imagine how much more intrinsic value could have been created if the PE stayed low?
Now, in reality, Apple’s PE rose and pulled forward the returns.
But some of the greatest winners were able to benefit from a multiple that didn’t rise, meaning an attractive shares repurchase yield could continue requiring only modest growth.
Who are These Winners?
There are 2 companies that immediately come to mind, which we are familiar with: Autozone and NVR.
They had 10-year CAGR of 20% and 22% respectively, and trade at average PE ratios of 18x and 15x.
Compare this with Apple’s CAGR of 26%, average PE of 21x, and more recently 5 year average of 27x! The comparative yield from deploying capital to buybacks is a disadvantage for Apple.
Lessons on Value Creation
We present a different way to think about enhancing intrinsic value:
1. Modest consistent growth rate
2. Ability to use free cashflows for repurchases
3. Persistently cheap multiples
You don’t hear anyone speak about this often.
Great compounders do not necessarily need high growth rates. In fact, high growth rates can lead to lousy capital allocation. For example, some management teams, when given lots of cash, will start to do expensive acquisitions. Or they are “forced” to buyback shares at expensive valuations to prevent dilution from paying high levels of SBC resulting from growth.