Part 3 – Lesson 11

Overview


Determining what makes a cheap valuation, fair valuation, or expensive valuation is the million-dollar question when building a financial model and evaluating the attractiveness of a potential stock investment.  There is also no straight forward answer to this question since it depends on multiple factors.

The current market valuation of a company reflects how other investors are currently valuing that business today.  Although markets are efficient, it is not perfectly efficient, so it is the investor’s job to determine if the current market valuation multiple fairly reflects the underlying fundamentals and financial performance of the business.

For example, let’s assume Company A manufactures the worst car in the market and has very little growth, but investors are ascribing a 30x P/E multiple to the company.  However, your fundamental research on Company A suggests that this a structurally disadvantage company that is unlikely to grow.  Given this research, a 30x P/E multiple would be considered very expensive.

Now, let’s look at Company B, which is also trades at 30x P/E.  Company B also manufactures autos, but it makes the best car on the market, and they are growing earnings 50% every year for the next 5 years.  Is 30x expensive for Company B?  Most likely not.  Instead, 30x is probably cheap for a company that is growing earnings at a such a fast rate and for a company with the best product on the market.

Whether or not a stock is cheap or expensive cannot be determined solely by the absolute valuation multiple.  Instead, it must be determined by looking at the valuation in conjunction with the fundamentals and growth of the business.

Valuation Multiples vs. Growth


Valuation multiples are positively correlated with growth, all else being equal.  In other words, the higher the growth rate in the underlying earnings or cash flow, then, the higher the valuation multiple that investors are willing to pay for that growth.

Below, we have created a table of cash flow multiples that we find to be attractive at various growth rates.  This is based on our preferences and investment bias, so other investors may have a different take on multiples they are willing to pay at certain levels of growth.  The below also assumes that underlying company fundamentals are strong.

Growth Rate in FCF/Share Price / FCF Multiple Range Notes
0-5% 9x-11x Our bias is to pay 10x cash flow for companies that generate steady but little growth in that cash flow
5-10% 11x-14x For modest growth companies, we are willing to pay a slight premium to 10x cash flow
10-15% 14x-16x Companies that consistently grow cash flow in the low double digits deserve a healthy cash flow multiple in the mid-teens
15-20% 16x-20x For faster growth companies, we don’t mind paying a cash flow multiple roughly equal to its sustainable growth rate.  For example, a company that grows cash flow at 30% for the next few years could deserve a 30x multiple, but we would not pay 30x if that company is projected to grow cash flow 30% for one year followed by 10% growth thereafter

Let’s look at an example of why investors are typically willing to pay a higher multiple for higher growth companies (Part 3 Excel download: Part 3 Download):

Note the following:

  1. For the high growth company, we have assumed that cash flow grows at 30% for the next number of years. For the moderate growth company, we have assumed a 10% growth rate in cash flow.

  2. For the 30% growth company, we are willing to pay 30x cash flow, and for the 10% growth company, we are willing to pay 12x cash flow based on 2018 FCF/share.

  3. Although we are paying more initially for the high growth company, look at what happens to the long-term valuations. By 2024, the implied P/FCF multiple for the high growth company now becomes cheaper at 6.2x vs. 6.8x for the moderate growth company.

  4. Additionally, if the high growth company is still generating 30% growth in cash flow beyond 2024, you can see how the long-term valuation multiples of the high growth company will ultimately be cheaper than the moderate growth company.

When deciding on the multiple you are willing to pay, it is helpful to run through an exercise (like the above) to see what the long-term valuation multiples look like.  Companies that seem expensive on today’s earnings or cash flow may ultimately prove to be cheap on long-term cash flow when growth rates are strong.  However, the reverse is also true.  There are many companies that trade at very attractive valuations today, but due to declining growth rates, these companies can look very expensive on long-term cash flow numbers.  We will discuss this in the next section.

Value Trap


Value traps are companies that trade at very cheap valuations on near-term earnings or cash flow numbers, but ultimately, prove to be bad investments because the business is facing significant headwinds and declining cash flow.  These types of investments are referred to as “value traps” since investors are “lured” into them by the seemingly cheap valuation.

Whenever you see a company that trades at 5x-8x cash flow or sometimes even 10x cash flow, you need to ask yourself if this company is in secular decline or structurally disadvantaged.

Let’s look at what happens to the long-term valuation metrics of a typical value trap:

Note the following:

  1. In this example, this company has cash flow that is declining at the rate of 15% per year. Due to the negative growth rates, the company trades at a seemingly attractive valuation of 9x cash flow on 2018 numbers.

  2. However, look at what happens to the valuation over-time. If you bought the stock at $18 today, you have effectively paid 20x cash flow on 2023 numbers and 23.9x cash flow on 2024 numbers.  A P/FCF multiple of 20.3x implies an FCF yield of 5.56% which is a very low yield for a company with declining cash flow.

  3. In practice, this stock would not stay at $18 by 2024 (and therefore trade at 23.9x FCF). Instead, the stock would likely maintain its low multiple of 9.0x and follow earnings downward.  For example, if the company maintained its 9.0x multiple, then, by 2024, the stock price would be $6.79 (9x FCF of $0.75).

From looking at this chart, you can see why this type of stock is called a “value trap.”  It appears cheap on 2018 cash flow, but due to the ongoing cash flow declines, the stock price will likely continue to trade lower every year.

Which valuation methodology should I use?


Throughout these lessons, it should be clear that our bias is to value stocks off Price to Free Cash Flow.  However, many investors prefer to use a discounted cash flow, sum of the parts, or other relative value multiples such as EV/Revenue, Price/Earnings, and EV/EBITDA.

We prefer to use P/FCF multiples since 1) an investor ultimately needs to receive cash flow for his/her investment and 2) cash flow is not prone to manipulation or accounting gimmickry.

However, when researching companies, an investor should always pay attention to what metrics other investors are paying attention to for that company.  For some early stage, high growth companies, investors may be valuing the business on EV/Revenue, particularly if the company is not yet generating cash flow.  For some consumer staples companies, P/E ratios are more commonly used by investors vs. P/FCF.  In the long-run, the choice of valuation methodology should not matter, but in the short-run, knowing which valuation metrics other investors are paying attention to will help you to understand near-term price movements.

Another important consideration is to also pay close attention to the operating metrics that a company is reporting.  For some companies, the stock price is more reactive to specific operating metrics than the actual underlying financials.  For example, Netflix stock is very sensitive to the quarterly net subscriber additions.  NFLX stock will trade up sharply if NFLX reports stronger than expected quarterly net adds even if the cash flow of the company is negative.  Investors are making the long-term bet that building a critical mass of subscribers will ultimately pay off vis a vis higher cash flow.