1/ Thread: The Math of Value and Growth @mjmauboussin
"The value of a financial asset is the present value of future cash flows. If you don’t believe that, please put this aside and resume your normal daily activities."
This disclaimer equally applies for this thread.
"The value of a financial asset is the present value of future cash flows. If you don’t believe that, please put this aside and resume your normal daily activities."
This disclaimer equally applies for this thread.
2/ Future cash flow is a function of TAM and growth economics.
"The holy grail is large markets with attractive economics."
"The holy grail is large markets with attractive economics."
3/ If companies invest heavily on intangibles, their income statement looks bad, and balance sheet appears better. This is true for many tech co's.
On the other hand, traditional companies invest on tangibles through higher capex and NWC, and their IS looks good and BS worse.
On the other hand, traditional companies invest on tangibles through higher capex and NWC, and their IS looks good and BS worse.
4/ "Two companies can have the same level of investment and return on investment but very different financial statements based on where accountants record investments. Free cash flow, the number we care about, may be the same but the path to get there is different."
5/ Multiples are not valuation, just a shorthand for the valuation process. Multiples often mask value drivers: growth, Return On Incremental Invested Capital (ROIIC), and discount rate.
Whatever the growth, when discount rate=ROIIC u pay commodity multiple i.e.1/cost of equity
Whatever the growth, when discount rate=ROIIC u pay commodity multiple i.e.1/cost of equity
6/ "The actual P/E multiple for the S&P 500 has been ~35% higher than the commodity P/E multiple since 1961, with most observations between 20 and 65% higher."
We'll see what happens to the multiples when we change some of the value drivers.
We'll see what happens to the multiples when we change some of the value drivers.
7/ Historically, when were P/E low?
When real interest rates were either very high or very low. Low rates and low growth go hand in hand which usually trumps the benefit of lower discount rate.
P/Es have been higher when interest rates are in the middle of the range.
When real interest rates were either very high or very low. Low rates and low growth go hand in hand which usually trumps the benefit of lower discount rate.
P/Es have been higher when interest rates are in the middle of the range.
8/ Here's something really interesting:
"Research shows that low Treasury yields allow industry leaders to generate excess returns and that the magnitude of those returns increases as yields approach zero."
Paper link: nber.org/papers/w25505
"Research shows that low Treasury yields allow industry leaders to generate excess returns and that the magnitude of those returns increases as yields approach zero."
Paper link: nber.org/papers/w25505
9/ Okay, let's get into the math now.
Mauboussin first shows what needs to be true to justify >30x P/E.
If the cost of capital is 6.7%, and a company can grow its NOPAT by 10% at ROIIC of 20% for 15 years, the P/E comes out to be 32.4x.
If NOPAT grows 15%, P/E would be 52.3x.
Mauboussin first shows what needs to be true to justify >30x P/E.
If the cost of capital is 6.7%, and a company can grow its NOPAT by 10% at ROIIC of 20% for 15 years, the P/E comes out to be 32.4x.
If NOPAT grows 15%, P/E would be 52.3x.
10/ What if growth turns out to be 12% instead of 15%? P/E falls down from 52.3x to 39.1x.
Assuming ceteris paribus, you are looking at 25% downside.
That's a key message: valuation is extremely sensitive to your growth assumptions.
Assuming ceteris paribus, you are looking at 25% downside.
That's a key message: valuation is extremely sensitive to your growth assumptions.
11/ "Growth makes little difference for businesses that earn a return close to the cost of capital but is a huge amplifier of value for high-return businesses."
High ROIIC means you need less capital to grow.
Low ROIIC means you need more capital to grow.
High ROIIC means you need less capital to grow.
Low ROIIC means you need more capital to grow.
12/ High growth stocks' P/Es are also VERY sensitive to discount rates.
If we change the discount rate from 6.7% to 6% for 15% NOPAT growth company, P/E increases from 52.3x to 63.4x.
For 10% NOPAT growth, P/E increases from 32.4x to 38.4x.
If we change the discount rate from 6.7% to 6% for 15% NOPAT growth company, P/E increases from 52.3x to 63.4x.
For 10% NOPAT growth, P/E increases from 32.4x to 38.4x.
13/ Contrast this with a low growth i.e. 3% growth stock.
Initial P/E is 18.0x. If you decrease discount rate to 6%, P/E increases to just 20.5x.
If you are a growth investor and haven't been grateful enough to Fed, now is the time to send a prayer or two to J Powell.
Initial P/E is 18.0x. If you decrease discount rate to 6%, P/E increases to just 20.5x.
If you are a growth investor and haven't been grateful enough to Fed, now is the time to send a prayer or two to J Powell.
14/ A word of caution: "While our core hypothetical examples assumed a business with very attractive economics, it is important to bear in mind that ROIICs eventually drift lower as a consequence of factors such as competition, maturation, obsolescence, and disruption"
End/ Because “In the long run, everything is a
toaster.”
Link to the full paper: morganstanley.com/im/publication…
toaster.”
Link to the full paper: morganstanley.com/im/publication…
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