Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 429

Why valuation multiples fail in an exponential world

“That company is expensive because its valuation multiple is high”. This is one of the most used and repeated phrases of market commentary. In fact, multiples are probably the most enduring pieces of investment analysis of all time.

Unfortunately, they are often completely useless.

The law of the instrument, or ‘Maslow's hammer’, is a cognitive bias where people rely too much on a familiar tool. The renowned American phycologist, Abraham Maslow, articulated this concept with his hammer and nail metaphor:

"It is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail".

Multiples are a short-cut, lazy approximation for valuing a business

For many market commentators and armchair enthusiasts, valuation multiples are their Maslow’s hammer, and they apply it indiscriminately, perhaps because it is the only valuation tool they possess in their toolkit.

Valuation multiples are a simplified, abbreviated and short-cut methodology for thinking about the value of a company. They blindly take a company’s price (market cap, enterprise value) and divide it by a fundamental metric (revenue, operating income, EPS, etc).

But they don’t tell the whole story or give a complete picture of underlying value and are prone to sizeable error when applied in isolation. And, sadly, multiples have never been less useful than they are today.

If investors can understand how multiples can mislead, and how to value companies in this new complex market, they will be better placed to identify and ride ‘multi-decade compounders’, such as the current and next generation of Amazons and Microsofts that build massive long-term wealth.

Multiples were not designed for today’s world

For traditional valuation multiples to be effective, a company needs stable and predictable cashflows, which are generally found in mature industries like utilities, real estate and infrastructure.

Multiples do a poor job of valuing privileged business models that have advantaged economics, including barriers to entry, network effects, and unique datasets. They also fail to reflect the value of emerging opportunities (aka real options) embedded in the world’s best businesses, including the likes of Facebook’s AR/VR platform and Alphabet’s AI unit.

Multiples provide an inadequate view when companies have high and relatively sustained growth rates, particularly for the world’s best software-driven ecosystems like Microsoft, Google, Amazon or in the alternative asset management space, like Blackstone, KKR, and Carlyle.

Basically, multiples simply break down when investors are analysing a disruptive company in the midst of an inflection or an industry that is adapting to a new world, a world we are seeing across myriad of sectors such as technology, healthcare, financials, transportation, and energy.

Humans are bad at exponential thinking

The core of the problem can be traced back to the fact that humans are very bad at exponential thinking. We prefer to use a simplifying linear concept (like a multiple) for a more complex non-linear concept (high growth business).

But we lose information, and that mapping mismatch can lead to errors and ultimately incorrect conclusions.

Google’s world-renowned futurist and Director of Engineering, Raymond Kurzweil, believes humans are linear thinkers by nature, whereas technology, biology and our environment are often exponential. That, he says, creates enormous blind spots when we pursue higher-order thinking and seek to solve increasingly complex problems.

Let’s consider a simple thought experiment often sighted as Kurzweil’s ‘law of exponential doublings’. It takes seven doublings to go from 0.01% to 1%, and then seven more doublings to go from 1% to 100%. So within 14 time periods an emerging system has gone from being completely invisible in the linear world (0.01%) to entirely encompassing it (100%).

The Covid-19 pandemic and the exponential spread of the virus gave us a real-world look at what exponential growth feels like as our lives were significantly disrupted. Yet most of us are simply not built to intuitively reconcile this phenomenon.

Visualizing exponential growth through doublings

Multiples meant investors missed massive Microsoft gains

Microsoft is an example of a company where the use of multiples fail. For the last decade the company has been consistently criticised by some investors for having an ‘extremely high multiple’ and is on the verge of a sharp pull-back.

This narrative continues to persist in parts of the market even today, yet Microsoft’s multiple has consistently expanded for the entirety of that time.

A linear conversation about Microsoft’s multiple ignores several underlying drivers of Microsoft’s valuation, from its virtual monopoly in enterprise computing (Windows), stranglehold on productivity applications (Office), to the enormous opportunity ahead of its cloud business (Azure).

Some six years ago Azure was an invisible real option within Microsoft, but it certainly feels real today after growing from basically zero revenue to an estimated $40 billion annualised run-rate (June 2021). Azure continues to grow at around 40-50% year-on-year with enormous runway ahead. 

Another fallacy is that Microsoft's market capitalisation gains have been entirely driven by multiple expansion and the low interest rate environment. Those factors certainly play a role, but multiple expansion only explains a third of Microsoft’s value gains.

While Microsoft’s multiple has expanded four-fold over the last decade, its market cap has increased nearly eleven-fold during that time, driven by a massive earnings inflection and exponential growth within Azure. That’s an extremely significant error produced by the unhelpful market heuristic of multiples.

Entrenched habits and lazy analysis have a long tail and multiples are a seductive short cut.

Microsoft’s multiple has expanded for a decade

How to value companies in today’s complex market

So if multiples mislead, how do investors value companies in this new environment?

There are no short cuts in valuing a business. It is a hard, detailed, and rigorous exercise that takes considerable time and insight to get right. At Montaka, our investment theses are fundamentally driven and we gain insights across the following areas:

  • Detailed, bottoms-up, DCF (discounted cash flow) assessment of each company we invest in with an exploration of business model economics, TAM (total addressable market), competition, etc
  • Top-down perspective of the markets the company currently serves and potentially will serve in the future
  • Considerable time is spent considering what the business and industry will look like in 5 to 10 years and what challenges / opportunities may be encountered (this is a never-ending cycle of course)
  • We also establish a set of valuation scenarios that are weighted by the probability of the scenario being reached. They guide our view around upside and downside, and color our level of conviction in the position.

We then effectively take a ‘time machine’ to several points in the future. For each time period we observe the multiple our valuation implies. This helps us check whether we are being too conservative, or too exuberant relative to what the market is willing to pay for the business today. In fact we often find instances where our DCF has compressed multiples in an unreasonable way or the market is being too conservative with its current price level.

Getting comfortable with high multiples

If we continue with Microsoft as an example, the current share price (US$300) implies the market is being extraordinarily bearish on the Azure cloud business, and also believes Microsoft’s future multiple will materially compress over the coming decade (from 37.0x to 13.5x).

We strongly disagree with the market’s assessment on both fronts and believe it is significantly underestimating Microsoft’s earnings potential and opportunity set, plus unreasonably discounts the quality of these earnings by slashing its multiple by more than half.

In fact, under our bullish scenarios, we believe Microsoft’s share price could increase several fold, even from here.

Significant multiple compression implied by current share

Compounding your wealth over decades

When an investor looks at a multiple, it may seem high at first glance. Certainly, a high multiple can be a red flag for overvaluation. However, in isolation an investor can’t draw any real conclusions from that multiple. 

Let's also look at Amazon for example. In 2006, it was trading at an EBITDA multiple of 26x versus the market (S&P500) which was trading at 10x. Certainly not cheap by typical measures.

But as a thought experiment, if we were to discount the current Amazon enterprise value at an annual rate of 10% back to 2006, an investor should have been willing to pay close to 690x EBITDA and they still would have quadrupled their money today. The market, however, materially undervalued Amazon and it went on to deliver investors 115x over that period. In fact, you could have paid double the share price for Amazon in 2006 and still made nearly 60x your money today.

Source: Montaka. Based on June-2021 LTM earnings for 2021 column.

At Montaka, our clear goal is to maximise the probability of achieving multi-decade compounding of our clients’ wealth, alongside our own. We are convinced that the months and years ahead will present opportunities to make attractive, multi-generational investments.

To achieve that, we won’t let multiples become our Maslow’s hammer!

 

Amit Nath is a Senior Research Analyst at Montaka Global Investments. This article is general information and does not consider the circumstances of any investor.

 

RELATED ARTICLES

Why it's a frothy market but not a bubble

The 'Heady Hundred' case for unglamorous growth

Why the tech giants still impress

banner

Most viewed in recent weeks

How to enjoy your retirement

Amid thousands of comments, tips include developing interests to keep occupied, planning in advance to have enough money, staying connected with friends and communities ... should you defer retirement or just do it?

Results from our retirement experiences survey

Retirement is a good experience if you plan for it and manage your time, but freedom from money worries is key. Many retirees enjoy managing their money but SMSFs are not for everyone. Each retirement is different.

A tonic for turbulent times: my nine tips for investing

Investing is often portrayed as unapproachably complex. Can it be distilled into nine tips? An economist with 35 years of experience through numerous market cycles and events has given it a shot.

Rival standard for savings and incomes in retirement

A new standard argues the majority of Australians will never achieve the ASFA 'comfortable' level of retirement savings and it amounts to 'fearmongering' by vested interests. If comfortable is aspirational, so be it.

Dalio v Marks is common sense v uncommon sense

Billionaire fund manager standoff: Ray Dalio thinks investing is common sense and markets are simple, while Howard Marks says complex and convoluted 'second-level' thinking is needed for superior returns.

Fear is good if you are not part of the herd

If you feel fear when the market loses its head, you become part of the herd. Develop habits to embrace the fear. Identify the cause, decide if you need to take action and own the result without looking back. 

Latest Updates

Economy

The paradox of investment cycles

Now we're captivated by inflation and higher rates but only a year ago, investors were certain of the supremacy of US companies, the benign nature of inflation and the remoteness of tighter monetary policy.

Shares

Reporting Season will show cost control and pricing power

Companies have been slow to update guidance and we have yet to see the impact of inflation expectations in earnings and outlooks. Companies need to insulate costs from inflation while enjoying an uptick in revenue.

Shares

The early signals for August company earnings

Weaker share prices may have already discounted some bad news, but cost inflation is creating wide divergences inside and across sectors. Early results show some companies are strong enough to resist sector falls.

Property

The compelling 20-year flight of SYD into private hands

In 2002, the share price of the company that became Sydney Airport (SYD) hit 80 cents from the $2 IPO price. After 20 years of astute investment driving revenue increases, it sold to private hands for $8.75 in 2022.

Investment strategies

Ethical investing responding to some short-term challenges

There are significant differences in the sector weightings of an ethical fund versus an index, and while this has caused some short-term headwinds recently, the tailwinds are expected to blow over the long term.

Investment strategies

If you are new to investing, avoid these 10 common mistakes

Many new investors make common mistakes while learning about markets. Losses are inevitable. Newbies should read more and develop a long-term focus while avoiding big mistakes and not aiming to be brilliant.

Investment strategies

RMBS today: rising rate-linked income with capital preservation

Lenders use Residential Mortgage-Backed Securities to finance mortgages and RMBS are available to retail investors through fund structures. They come with many layers of protection beyond movements in house prices. 

Sponsors

Alliances

© 2022 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. Any general advice or ‘regulated financial advice’ under New Zealand law has been prepared by Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892) and/or Morningstar Research Ltd, subsidiaries of Morningstar, Inc, without reference to your objectives, financial situation or needs. For more information refer to our Financial Services Guide (AU) and Financial Advice Provider Disclosure Statement (NZ). You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.