What Does a Price-Earnings Multiple Mean? By Michael J. Mauboussin

[kla2]

Hi everyone.

This an interesting report that everyone should read.

http://www.valuewalk.com/wp-content/uploads/2014/02/document-805915460.pdf

I agree with the broader premise but I have a few doubts.
I hope someone can answer them.

1. On page 3 he gives a formula for Future value creation. I agree with the numerator but do not understand how the denominator was derived at. Why does it have to be Cost of Capital (CoC) plus CoC[sup]2[/sup] ?
2. On page 10 exhibit 5, why does the multiple for 4% ROIIC go from 7.1 (for 4% earnings growth) to 3.3 (for 6% earnings growth)? I am not asking specifically about the numbers, but why does it decrease at all.
   Is it because when the ROIIC is less than CoC, earnings growth will negatively compound value creation, which would lead to a downward spiral (even though earnings are growing) and thus reduce the multiple and attractiveness of the security?

Any opinions are appreciated!

 

[fixn2fly]

@kla2

1. If you take out CoC on numerator and cancel with denominator, the it becomes similar to Investment* growth rate* time/(1+CoC). This should approximation of (1+x)[sup]t[/sup] series, x

 

[kla2]

@fixn2fly Thanks for the effort!

1. I don't get your first point. How can CoC be taken out? Some other user commented that the second CoC is just a constant arbitrary growth rate of CoC. What do you think about that?
2. You are using ROIC instead of ROIIC. Any reason for that?

 

[fixn2fly]

@kla2

1. ROIC is return on invested capital. Paper is using ROIIC as return on incremental invested capital. They were more accurate in notation though used to represent the same.
2. If we do it using cash flow discounted.Additional investments, leads to additional cashflows discounted by Coc i.e. (1+CoC)[sup]n.[/sup] Hence the term (1+CoC) is there. If you expand incremental cashflows in terms of (NOPAT0 + ROIIC*I sum series, and approximate (1-x)[sup]n[/sup] series, the formula mentioned there will be obtained which will have a 1/CoC term. You can try the math want to dig deeper, however, the paper is more theoritical than practical.

 

[zelda_freak]

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