Most investors tend to implicitly assume there is some reasonable range of multiples at which most, or all, companies should trade relative to the market. Usually, this notion of ‘reasonable’ is based on a historical average or a peer group of similar companies. Multiples, however, have become a shorthand for the valuation process.
Importantly, multiples obscure the value drivers that really matter. It is the value drivers that determine the reasonableness of the multiple, not the multiple that determines the reasonableness of the valuation. More specifically, the market value of a company and its associated valuation multiple can be broken down into two main parts:
The steady-state value is the straightforward function of prevailing risk-free capital market rates and the equity risk premium, which itself depends on aggregate investor risk appetite at a given point in time. The steady-state value of a company can vary a lot over time, as both capital market rates and investor risk appetite fluctuate.
Differences in multiples across companies are determined by differences in expected future value creation
However, this does not cause divergence in multiples across companies. Differences in multiples across companies are determined by differences in expected future value creation. Companies that earn high returns on future investments, have sizeable profitable investment opportunities and can be expected to maintain their competitive
Figure 1 shows the theoretical multiple trajectory of a fictitious company that starts out with a positive spread of 25% over its 8% cost of capital. The spread is assumed to erode by 1% every year, so that the firm’s competitive advantage will last 25 years. Assuming perfect prescience, investors should be willing to pay a seemingly astronomical P/E multiple of 96.9 at the start of this company’s life.
This high multiple is warranted, however, by the prospect of 25 years of profitable, value-creating growth. As the company matures over time and steadily realizes its growth opportunities, the justifiable valuation multiple will slowly converge towards the steady-state P/E multiple of 12.5 (1/8% after 25 years), reflecting the shrinking prospects for future profitable growth.