Valuation is a critical component of active investment management, yet many investors restrict themselves to a very narrow view of valuation by focusing on simple metrics like the price/earnings (P/E) ratio. In this article, Global Leaders portfolio managers Mick Dillon and Bertie Thomson discuss the dangers of oversimplifying valuation. They also explain why they focus squarely on a company’s business model as the ultimate measure of its intrinsic value.
When it comes to the thorny issue of valuation, we share the view of one of our favorite financial thinkers, Alfred Rappaport: “Cash is a fact, profit is an opinion.” Rappaport, author of the seminal text Creating Shareholder Value, made this statement in specific reference to the limitations of using accounting profits vs. cash flow. Accounting profits, or earnings, are subjective, easily manipulated and influenced by the vagaries of accounting, while cash flow is objective and much harder to fudge. For this and other reasons, we believe that earnings are a poor measure of a company’s value. This makes ratios like the P/E ratio dangerous as a valuation tool.
Discounted cash flow analysis is the foundation of our valuation work. Free cash flow generation should be the key output of any enterprise, so we value every enterprise based on the net present value of its future cash flows. Crucially, this analysis values a business in its entirety by examining the total cash flow produced and separating it between different claimants, most notably creditors, and the last to get paid—ourselves the shareholders. This also means we implicitly bring a company’s balance sheet into the valuation equation. We believe that investors who ignore an enterprise’s sources of financing when valuing it do so at their peril. As we discuss in this article, we focus on cash flow—its sustainability, its likely growth trajectory and the portion we are entitled to as equity owners.This is a cornerstone of our investment philosophy and the starting point for all of our investment decisions. During our valuation work, based on cash flow analysis, we focus on absolute valuation as opposed to short-cut valuation metrics relative to benchmarks or peer groups.
Most market participants forget that multiples are valuation shorthand that embed several of a company’s key value drivers into a single number. Simple ratios like P/E create mental shortcuts that appeal to our automatic and responsive mode of thinking. Daniel Kahneman famously distinguishes this as System 1 thinking, which he describes as fast, instinctive and emotional, from our slower, more deliberate and logical System 2 thought process.
Heavy users of P/E multiples deride the complexity of using discounted cash flow analysis. They forget that the multiple still encompasses this complexity, or they simply choose not to verify the many assumptions buried in the single ratio on which they rely. Left unchecked, the human mind prefers the easy way out—the path of least mental resistance.
One of the key embedded assumptions within the P/E ratio is return on invested capital (ROIC). ROIC is a measure of financial productivity; we view it as the missing link between sales and free cash flow. The higher the ROIC, the more free cash flow is produced per unit of sales. Companies only create value when their ROIC exceeds their blended cost of capital—in other words, when a unit of the company’s free cash flow exceeds the capital unit cost of generating it. ROIC is also a key determinant of a company’s sustainable growth level, which is a function of the reinvestment rate of its cash flow and the expected return on that reinvestment. For example, a company with a 10% ROIC needs to reinvest 100% of its cash flow to grow at 10%, whereas a 20% ROIC company will need only a 50% reinvestment rate to grow at the same level of 10% (20% ROIC x 50% reinvestment rate). The 20% ROIC company clearly has more flexibility because of its higher ROIC. It can decide to invest more cash flow to drive higher growth or keep reinvesting at 50% and use the excess cash flow to improve its balance sheet. In this example, there is no prize for guessing that the company with a 20% ROIC is more valuable than the one with a 10% ROIC, all else being equal. ROIC, reinvestment rates and sustainable growth rates are three variables that largely slip below the radar in the one-eyed world of the multiple-focused investor.
Given our approach, we are naturally wary of the investment community’s overreliance on P/E and other valuation multiples. Although widely used by most investors, P/E ratios have a number of limitations. As already mentioned, earnings are based on accounting. Managers can easily manipulate conventionally accepted non-GAAP adjusted earnings figures with a multitude of perfectly legal techniques; subjective omission or reclassification of certain costs is perhaps the most obvious example. In addition, the P/E multiple crucially ignores the structure of a balance sheet. As an example, two companies with similar outlooks may both trade at 15 times earnings, but one may have no debt, while the other’s debt levels may be double or triple that of its equity value. Again, it is obvious that the first company is more valuable despite the P/E parity.
Lastly, P/E ratios ignore a company’s competitive advantages and they ignore how a company’s advantages manifest in its ability to sustain its ROIC. Competitive forces dictate that a company’s ROIC will trend towards its cost of capital over time. We look for highly productive, high-ROIC companies and we look for “fade-resistant” businesses that can leverage competitive advantages to generate excess returns for extended periods. Competitive advantage and fade periods can be expressed in discounted cash flow analysis, but like the other factors discussed above, they are buried invisibly within a price multiple.
Although using multiples for valuation presents numerous problems, they do have certain uses. They aid speedy comparisons between similar business models when factors such as ROIC, growth and fade are part of the discussion. With this in mind, we consciously view multiples as outputs rather than inputs of the key variables of value creation. Accordingly, we frequently use multiples as a means of asking ourselves what the equity market seems to be pricing into a company’s share price. This involves deconstructing multiples into the core variables of ROIC, growth, reinvestment and fade, which helps us ask thoughtful questions about the implied values, even if we cannot derive definitive answers. This can be a useful complement to our primary approach of discounted cash flow analysis, as we try to reverse engineer the expectations implied by a company’s share price.
Arguably, the biggest benefit that we derive from P/E multiples is the frequent inefficiency that occurs in a stock’s price when investors overly focus on this shorthand valuation technique. For example, we largely avoid “hot” investments with high P/E multiples; in many cases, investors justify these multiples by looking at near-term earnings growth, without realizing that a company is destroying value because its ROIC is actually below its cost of capital and that its growth trajectory would require an unsustainably high reinvestment rate. Conversely, short-term investors may be put off by an artificially high P/E multiple when a company is undergoing a business model transition, but by using discounted cash flow analysis, we may see a path for significant long-term value creation. In these and other situations, the market’s myopia regarding multiples can create opportunities for the long-sighted, cash flow-centric investor.
We will close by saying simply that the proof is in the pudding. We believe that the Global Leaders portfolio represents an attractive investment opportunity when viewed through the lens we use in our valuation work. As shown in the table above, our portfolio was essentially in line with its benchmark in terms of P/E ratio at the end of 2017. However, when looking at free cash flow yield (which, as discussed above, we consider a far more accurate measure of value), the portfolio was trading at nearly a 10% discount to its benchmark. Alongside this valuation discount, the portfolio’s sales growth was nearly double that of the benchmark, and its ROIC was nearly three times as high.
This favorable profile is indicative of a group of businesses that have been highly productive with capital and offer strong potential for sustainable and faderesistant growth. When we measure value based on the inputs of value creation rather than a single output, we see a portfolio that offers attractive absolute and relative characteristics.
By focusing on crucial variables such as ROIC, reinvestment rate and fade, we are confident that we can outperform a market that we believe leans too heavily on the shorthand of valuation multiples. 
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Price-Earnings Ratio (P/E Ratio) is the ratio of the share of a company’s stock compared to its per-share earnings. P/E calculations presented use NTM (next twelve months) earnings estimates.
ROIC is a measure of determining a company’s financial performance. It is calculated as NOPAT/IC; where NOPAT (net operating profit after tax) is (EBIT + Operating Leases Due 1-Yr)*(1-Cash Tax Rate) and IC (invested capital) is Total Debt + Total Equity + Total Unfunded Pension + (Operating Leases Due 1-Yr * 8) –ExcessCash. ROIC calculations presented use LFY (last fiscal year) and exclude financial services.
FCF Yield is a measure of financial performance calculated as operating cash flow minus capital expenditures. FCF yield calculations presented use LFY and exclude financial services.
Sales Growth Rate is based on reported company revenue for the past three years at the end of the current quarter, provided as a historical average.