Valuation expansion is an important concept that, if used correctly, can enable investors to achieve superior returns and avoid overpaying for a stock. Unfortunately, it's easy to underestimate its importance because it can appear to be an esoteric concern, so I'll try to keep things straightforward.
What is valuation expansion?
Simply put, valuation expansion occurs when the market assigns a higher multiple to a company's earnings, cash flows, or any other valuation metric you might choose to use. For example, before a valuation expansion, a stock with $10 in earnings might trade for 10 times its earnings, so its share price would be $100.
Fast forward one year; the company has generated $15 in earnings, and the market has decided to expand the valuation multiple on the stock (valuation expansion) to 20 times earnings, so the stock now trades at $300. In other words, it's tripled in value.
It's essential to pause and understand that if the valuation expansion hadn't occurred, the valuation would have been 10 times the $15, so $150. In addition, note that if its earnings had stayed at $10, but the market had still granted the stock a valuation expansion to 15 times earnings, the new valuation would be $150.
As such, valuation expansions are significant for returns and can produce excellent returns even if earnings stay the same.
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Using valuation expansion in investing
The examples above illustrate how investors might identify an aspect of a company's fundamentals, industry trends, or market sentiment that will result in the market pricing in a valuation expansion for the stock. This is a useful tool in any investor's arsenal, and utilizing it can lead to good returns.
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