FOOL ON THE HILL
With the recent decline in many stock prices, investors are turning their attention to earnings multiples, P/E levels, and the idea of "multiple compression." But how are multiples determined in the first place? Growth rates, macroeconomic factors, and other outside issues all play a role. But instead of guessing at future stock P/Es, investors should focus on such business fundamentals as return on capital.
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Explaining why stock prices go up or down on any given day is not the easiest job in the world. A myriad of factors can affect a company's valuation in the marketplace from day to day. Typically, though, the bulk of the motivating factors point back, either directly or indirectly, to future earnings growth. Since the future is unknowable, projections about future earnings growth can be pretty sensitive. All kinds of things can throw them off, everything from news that a certain product isn't selling well to a bearish call from an influential analyst or an outbreak of mad cow disease in an important market. Given the daily emphasis on future earnings growth, it might seem that this is the only factor long-term investors should be worried about. The unspoken conclusion is that nothing will determine a stock's long-run performance more than its future earnings growth. While this belief has become accepted wisdom in certain investing circles, it has a big hole in it: It's not an absolute truth that if you can identify a company that will generate 15% earnings growth annually like clockwork for the next 10 or 20 years, you'll end up with a compounded rate of return of around 15%. It's quite plausible that you may end up with quite a bit more -- or quite a bit less. What bridges the gap between a company's earnings growth and the long-term rate of return from its stock is the value placed on those earnings by investors, both when the stock is first purchased and when it is ultimately sold. This value is most commonly expressed by the earnings multiple, otherwise known as the price-to-earnings (P/E) ratio. In recent months, the P/E ratio has become a bear market hobgoblin in many investors' minds, particularly those who invested in some of the many technology-related stocks that fetched triple-digit P/E ratios as recently as last fall. It's undeniable that projections for lower future earnings have weighed heavily on many companies' stock prices over the past few months. Such bad news is enough to cause a pretty steep price drop for just about any company, tech or otherwise. But what creates an outright crash in price is when not only do the projections for future earnings go down, but the multiple placed on those earnings slides as well. This is Wall Street's double whammy, giving rise to the condition known as "multiple compression." Multiple compression can create some nasty results, as in the case of communications chipmaker Broadcom (Nasdaq: BRCM). The declining earnings picture doesn't tell the whole story for what has happened to this stock over the past six months. According to First Call, the company is expected to earn $0.41 per share this year. Based on its multiple of 248x forward earnings six months ago, that would put Broadcom's share price at just over $101 per share today -- had the multiple held up. Unfortunately for Broadcom investors, it didn't. Broadcom's current multiple is a reduced 70.5x, producing Friday's share price of $28.90. The $72 share price difference is the work of multiple compression, expressed in dollar terms. A similar situation has taken place with a number of stocks. (I don't mean to pick on Broadcom exclusively, as it is just one example.) While many investors in "multiple compressed" stocks may have a newfound respect for how the earnings multiple factors into long-run investment returns, many elementary questions about the multiple's importance remain. What is the "right" P/E level for a given company? It isn't chiseled in stone somewhere, so how should investors go about determining it in their own minds? And how realistic is it to set expectations about what the earnings multiple level might be for a stock five, 10, or 20 years down the road? What makes these questions so hard to answer is that the value placed by investors on a company's future earnings depends on a variety of factors. The outlook for future earnings growth plays a large role. Certainly, the growth rate matters, but what can matter even more over long periods of time is the sustainability of a given growth rate, even one that may appear low by today's standards. In fact, if you assume a sustained growth rate of just 5% or 6% for a company over a long enough period of time, strange things start to happen due to the math involved. So long as the future earnings are discounted back to today at a rate that is lower than the growth rate, the present value of an infinite grower (and therefore, its justified earnings multiple) can approach infinity. [For more on this mind-bending "infinite grower" concept, check out the Tweedy, Browne Company research report Investing for Higher After-Tax Returns.] Over shorter -- and, frankly, more realistic -- time frames, there are other factors that influence the "right" earnings multiple level for a company. Changes in interest and inflation rates are two macroeconomic factors that can and do affect the present value of future earnings, influencing the multiple in turn. Changes in legal items such as the expiration of an important patent or copyright can also affect the multiple, since such items relate directly to the issue of the sustainability of a company's profits. But perhaps nothing affects the value placed on a company's earnings more than the way those earnings are generated in the first place. The higher the level of earnings a company can produce in relation to its capital employed, the more those earnings are "worth" in present dollars. As investors like Berkshire Hathaway's (NYSE: BRK.A) Charlie Munger and others have pointed out, the rate of return from a stock over time will equate to the underlying return on capital of the business. If there is any relationship for the long-term investor to focus on, it is this one. In the end, looking for and identifying companies that will be able to earn higher than average returns on capital for extended periods of time is the best weapon for an investor to defend against the possibility of future multiple compression. Steering clear of ludicrously high prices and stocks with extremely high future expectations is not a bad idea either. But by using a concept such as return on invested capital (ROIC) in the analysis process, the investor is making a stand on the future prospects of the business. While determining a company's future business performance is by no means easy, it's a lot more realistic than trying to randomly gauge what multiple an oftentimes fickle market will place on your stock at some point down the road. Brian Graney had multiple reasons for writing this column, and multiple excuses for why it got turned into the Fool's editors so late. At the time of publishing, he owned shares of Berkshire Hathaway. The Motley Fool is investors writing for investors.
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