Exposing the Flaws of the Most Commonly Used Investing Metric

As Managing Director and Head of Global Financial Strategies at Credit Suisse, Michael Mauboussin advises clients on valuation and portfolio positioning, capital markets theory, and competitive strategy analysis. He has also authored three books -- Think Twice, The Success Equation, and More Than You Know -- and is an adjunct professor of finance at the Columbia Business School, and chairman of the Board of Trustees at the Santa Fe Institute.

What do we really know about P/E? In the video below, Mauboussin discusses a framework for evaluating the Steady State Value and Future Value Creation of a business, and what those two factors can tell us about how much of the company's P/E is being attributed to future growth.

A transcript follows the video.

Koppenheffer: In a recent piece of yours, you broke apart the two main components of price to earnings ratio, the P/E ratio that everybody talks about. One of the things that you said was that a lot of investors don't use discounted cash flow models, which is a way to value a stock.

Just about everybody uses the P/E, but they're not really using it correctly. Can you explain that a little bit?

Mauboussin: Sure. The first thing I'll say is, the value of any financial asset -- whether it's a bond or a stock or real estate, it doesn't make any difference -- is always the present value, future cash flows. I don't think anybody would disagree with that. It's very foundational.

Yet, in the investing world, the equities world particularly, we use a lot of shorthand as you pointed out. Price to earnings multiple; price of the stock, divided by earnings -- usually next year's earnings -- that's a shorthand that almost everybody uses.

Sometimes, a little more sophisticated, people talk about enterprise value, the EBITDA; earnings before interest, taxes ... the same basic concept.

The first thing I'll say is, these are shorthands for the actual valuation process. They're not valuation. They're shorthands for the process. What's good about shorthands? They're quick. What's bad about shorthands? They sometimes have biases.

What I want to do there is say, let me just take a big step back and say, if you're thinking about a P/E multiple, what is really foundational here? What do we really know?

I went back to the most seminal paper on valuation, written by two academics in the 1960s, where they said, "You could think about the value of a business in two pieces."

One is what they called the Steady State Value. This is what the business would be worth if they had the current earnings today, and did it forever. One way you might think about that is, let's say McDonald's (MCD -0.42%) never built a new restaurant. The restaurants they have today are all you'll ever see. What would that be worth? They can earn what they're earning now for a pretty long time.

The second component these academics talked about was what they called Future Value Creation, which is the investments that will earn excess returns in the future. In the McDonald's example you might say, "These would be the stores they will build in the future, that will create value."

Both of these things, together, is the total value of the company.

What's cool about this is that we can take the Steady State Value and then we can figure out the P/E multiple that should be attributed to that piece. Then we can figure out, if the P/E is above that, what is being attributed to the future.

To be concrete, roughly -- on current interest rates and equity risk premium -- the base steady state P/E multiple is about 12.5x. So, if you are looking at a stock that's trading over 12.5x, what that implies is you're paying something for future value creation. Then the question becomes, how much are you paying? Is that a reasonable thing to pay?

I just think it's an extraordinarily useful framework for thinking about what those P/E multiples mean, and the relative contributions from what we've got in the bank, versus what's on the come.

Koppenheffer: In terms of valuing that growth component of it, that's where interest rates can come into that, and all that kind of stuff as well, so you've got a lot of different moving parts in there as well. Is that correct?

Mauboussin: The value creation piece, there are really three big things. Things like interest rates and equity risk premium are very difficult to predict, so the three big things are:

One, what will the returns be on incremental investments? Am I going to invest in something with very high returns, market returns, or below the cost of capital returns?

The second component is, how much money can I invest? Sometimes you can have small spreads above the cost of capital but you can do a lot. Other times, you have high spreads but you can't do that much, so how much do you invest?

The third component is, for how long you can find investment opportunities? Because it's a finite world, and there's a lot of competition. The idea is, how long can I find investments that are profitable in this way?

Return on invested capital is the first component. The second component is the amount of investment, and the third is this time horizon component. Those are the three things that comprise that present value, future growth.