Study: PE ratio, Mean Reversion, Returns on Invested Capital

PE ratio and Mean Reversion

The formula is simple for PE ratio = Share Price / Earnings per Share

Calculating it is straightforward as the EPS (earnings per share) can be found on the income statement. The problem with the PE ratio comes from its interpretation; not its calculation.

Intuitively, the higher the PE ratio means a higher expected growth rate of the company. Simply put, if a company is expected to produce above-average growth, it will most likely have an above-average PE. Conversely, if a company is expected to have below-average growth, the market will assign a below-average PE.

Ultimately, PE ratios tend to converge to the mean once growth slows down and the company goes into a steady state. The rationale is that high growth doesn’t last forever, and competitive advantages are eventually competed away.

Mean reversion works both ways. Suppose a company has a lower-than-average PE but achieves average EPS growth. In that case, the PE ratio should eventually converge upwards to the average, so investors enjoy some of their return from a multiple expansion. Conversely, suppose a company has an above-average-multiple but cannot produce above-average growth. In that case, the PE multiple will fall.

Investors typically look for companies that are under-appreciated by the market, hoping to buy them at a discount and realizing most of their gain from a multiple expansion once the market recognizes the mispricing.

In our opinion, it’s a weak strategy, as the returns would depend more on how the market values the company’s cashflows and not the ability to generate cashflows. There is also a need for timing, not just for the company’s results, but also for the market’s reaction to it.

Mean-Reversion Strategy Doesn't Drive Returns

Consider this perfect timing portfolio starting from 1920 (PE 4.8x) to 1999 (PE 44.2x). Between these 79 years, the S&P500 index had total returns CAGR of 11.4%.

PE expansion contributed only 2.8% and the remaining 8.6% came from business performance.

This highlights the fact that even with perfect timing on buying at the lowest multiples and selling at peak multiples, the bulk of total returns over a long period of time is due to business performance, not multiple expansion.

ROIC and Reinvestment Rate

We might be inclined to believe that two companies with the same expected EPS growth should trade at exactly the same multiple. However, this is not the case in reality.

Why so? The answer lies in the cash generation capacity.

Not all growth is created equal, so we must consider the variables driving earnings growth. It determined by the product of reinvestment rate and the return on invested capital (ROIC).

Earnings growth = Reinvestment rate * ROIC

The reinvestment rate measures the proportion of earnings that the company puts back into the business. The ROIC measures the return it makes on these reinvested earnings.

For example, to generate 10% earnings growth, a company can have a multitude of combinations:

• Reinvest 100% with ROIC 10%

• Reinvest 50% with ROIC 20%

• Reinvest 25% with ROIC 40% etc…

The Best Combination?

This answer is not as straightforward as it seems. We might be inclined to think that reinvesting less to achieve the same level of growth is always preferred. This is true in most cases, but high reinvestment needs also serve as strong moats that help ward off competition. If a company can grow with very little reinvestment, a disruptor might be able to compete without needing too much initial capital.

For the sake of generality, let’s assume the lower the level of reinvestment required is better to achieve a given growth.

Why is this assumption logical?

The goal for any investor is to make a positive return, and this return comes from the difference between the price paid and the cashflows received. So, for example, if we pay $100 for an asset and want to realize a 10% annualized return over 10 years, we must get $260 in cashflows; which can come from recurring cashflows and/or selling the asset for a higher price.

In the case of an equity investment, the recurring cashflows come from the company returning excess cash to shareholders via dividends, share repurchases, or from selling the shares at a higher price.

If a company spends less to grow, there’s more cash available for shareholders, and thus there’s a potential higher return from dividends or share repurchases.

Comparing PE ratios

When we see a divergence between the PE ratios of two companies with similar growth prospects, we should first look at the underlying earnings growth drivers instead of claiming that one is expensive and the other is cheap.

The higher PE company might have more cashflows available for shareholders. It is wrong to judge whether a company is cheap or expensive based only on the PE ratio and a growth rate.

Some investors will try to use PEG ratios, but it also fails to capture the movement in the underlying growth drivers.

True Growth Drivers

This leads us to the underlying growth driver, which is the ability to generate cashflows.

All things equal, the higher the ROIC spread versus cost of capital, the higher the PE ratio can be without impairing the required returns.

If the spread is negative, then there’s value destruction with growth. When the spread is zero, growth does not create value. However, when the spread is positive, there’s value creation with growth. This value creation is much better at higher ROIC spreads because the company can achieve it while having more cash for distribution to shareholders.

The answer always lies in cash, and despite the PE ratio being an income statement ratio, the conclusion is no different.

Why High Quality Companies trade at High PE ratios?

High ROIC spread is one of the reasons why high-quality companies tend to trade at high multiples. These companies typically have high ROIC spreads and thus don’t need much reinvestment to create growth.

Unfortunately, there’s difficulty in trying to adjust current PE ratios for ROIC spread. Because the market is future-looking, so the reason why they trade at premium multiples is not due to a current high ROIC spread but because the market believes that this ROIC spread will be maintained going forward.

Limitations of DCF

Mean reversion is a powerful force of capitalism that impacts most businesses. However, a minority group of companies can protect their returns through competitive advantages, which allow these companies to defer mean reversion, enjoying higher returns for extended periods than traditional valuation models would account for.

For example, the discounted cashflow (DCF) model was not made for companies that can sustain high returns over time. It was designed for the vast majority of companies that experience mean reversion. For this reason, DCF models typically forecast a few years out and apply a terminal growth rate that is lower than GDP growth, such that growth falls to steady state and excess returns are competed away.

This assumes that mean reversion happens quickly, making DCF models ill-equipped to forecast the cash flows of companies with strong moats. If we drop the growth of a high-quality business after a few years to steady state, the model is missing a very large portion of the free cash flow creation of the business.

This is why high-quality companies will almost always appear optically overvalued using a standard DCF model. The limitations of this model make it almost impossible to grasp the future sustained earnings power.

Solutions to Modelling

There are 3 ways to solve this DCF problem.

The first and most obvious one is projecting a higher terminal growth rate. But we must be careful not to apply a higher than GDP rate, or else we would be implying that the company eventually gets larger than the economy.

The second method is the inverse DCF. By working backward, we solve for what growth is baked into the stock price. Then we judge if this growth rate is reasonable.

The last method that we prefer is not to spend time calculating at all! Instead, most of our time should be spent understanding the economics of the business. Valuation should be so obvious that we don’t need to run models.

Therefore, the most important question an investor should ask is: “How likely is this company able to sustain high levels of earnings over the next few decades?”

In other words, there’s no way to tell if a business is cheap or expensive just based on multiples or DCF.

What the Market Knows

Everything above is not new knowledge, and the market is well aware of the true underlying drivers of growth. But what the market fails to account for is the durability of competitive advantages over long periods of time.

Of all the possible advantages that investors can have, the “time advantage” is probably the most relevant and the easiest to exploit.

The rationale is that Wall Street can’t look that far out due to its incentive schemes, and most people are unwilling to slowly compound their capital at the risk of boredom.

So, we can conclude that these 2 factors contribute to a successful investor:

1. Deep understanding of business economics stemming from industry competency

2. Long time horizon

Both of which have nothing to do with PE ratios or valuation models.