About valuation

Valuing a company is one of the most complex exercises in finance. We can't think in terms as simple as "a P/E ratio of 10 is cheap, and a P/E ratio of 30 is expensive". The exercise of valuing a company or a market is far more complex, because not all earnings are the same, just as not all macroeconomic contexts are the same. Many parameters influence valuation, both from a macro perspective (the level of risk-free rates, GDP growth, a country's indebtedness, a sector's regulatory constraints, political orientation, etc.) and from a micro perspective (the stability and level of margins of a company or market). and margin levels, total addressable market (TAM) potential, balance sheet quality, market positioning, etc.). This article aims to deconstruct the idea that a company is expensive or cheap simply by reading its valuation multiples, and to instill the idea that quality is more important than price if you're investing for the long term.

A high valuation doesn't mean you're paying too much. A company's quality can sometimes be worth paying 30 or 40 times its annual earnings. Terry Smith, a leading investor and analyst at Fundsmith, used to say that "just because a company is cheap doesn't mean it will become a good company, and in the long run, it's the quality of the company you invest in that determines your return".

Focus on return on capital employed

"Over the long term, it's difficult for a stock to earn a much higher return than the company behind it. If the company returns 6% of capital over forty years, and you hold it for that period, you'll get little more than a 6% return, even if you bought it at a steep discount to begin with. Conversely, if a company returns 18% of capital over twenty or thirty years, even if you pay a high price for it, you'll get an excellent result." - Charlie Munger

And to illustrate this point, nothing could be better than an example.

Let's take two companies with the following characteristics:

  • Company A has a return on capital employed (ROCE) of 20%.
  • Company B has a return on capital employed (ROCE) of 10%.

Neither company pays a dividend. They reinvest 100% of their after-tax profits in growth. Let's assume they have the same tax rate and maintain the same level of ROCE over the long term.

Now, let's imagine that it's 1990. If you wanted to invest in one of the two companies mentioned (A or B), which would you choose if you had to hold your investments ("buy and hold" strategy) until 2023?

Before answering this question, I'd like to make two important points about valuation:

  • In 1990, if you bought company A, it would be valued at a P/E ratio (i.e., price/earnings) of 30, while company B would pay half that, with a P/E ratio of 15.
  • In 2023, when you sell your shares, if you own company A, its valuation will be halved. The 1990 P/E of 30 will fall to 15 in 2023, on the same projected earnings, which will inevitably lower your price. Conversely, if you are a shareholder in company B, the P/E of 15 in 1990 will rise to 30 by the time you sell in 2023, which, on the basis of the same estimated profits, will double your selling price.

Taking these remarks into account, in which company would you like to invest at the dawn of 1990?

The answer in pictures:

As you can see, even with very bad timing on company A, your final gain is more than 4 times greater than on company B, and this even if you had exited with very good timing on the latter. In the end, your investment in a better-quality company gave you an annualized return of 16.95%, compared with 11.95% for the average-quality company, i.e. 5% more every year!

Use inversion to find quality

Even with this illustrated theoretical explanation, you might say to me: "But all this is idyllic. In real life, no company grows at this rate for so long and manages to maintain a high rate of capital employed".

It's true that only a few very fine companies manage to maintain such a high rate of growth. To find them, the key is to narrow down your investable universe using selective criteria regarding the quality of the companies you're looking for. Instead of finding the best companies, do the opposite: eliminate the bad ones. You'll see, it's much easier.

The "quality" investment style seeks to eliminate companies that are :

  • unprofitable (negative net margin) or not very profitable (net margin below 5%, for example) ;
  • poorly profitable (low return on equity (ROE), return on invested capital (ROIC) and return on capital employed (ROCE), let's say below 15% to set a limit);
  • whose margins are volatile from one year to the next, and whose earnings are unpredictable. Certain business sectors with low cyclicality and companies with recurring revenues will therefore be favored.
  • have a fragile balance sheet with high financial leverage, i.e. unreasonable debt in relation to pre-tax profits, free cash flow, shareholders' equity or total assets.

There are very few companies that really deserve your attention, so don't be afraid to be too selective. If your aim is to find and hold companies over the long term to beat the market, you should seek to select companies that create value for their shareholders, generate a high return on capital employed that reinvest earnings in their growth, and that can sustain these high levels of profitability and growth over the long term thanks to significant market potential, a sustainable competitive advantage and a fortress balance sheet.

With a sufficiently diversified portfolio of high-quality companies, several studies show that you can pay on average four times the market price/earnings ratio and still perform as well as the market over the long term.

Putting it into practice with remarkable track records

To show that all this can be explained in practice, let's go back in time again.

The year is now 1973.

Let's take a few examples of international companies that you could have paid a very high multiple (in terms of P/E ratio) and still outperformed the world index (MSCI World) over the same holding period (from 1973 to 2019).

Imagine, you could have paid L'Oréal 281 times its earnings in 1973 and still achieved a better performance (7% CAGR) than the MSCI World (6.2% CAGR).

Humans sometimes find it hard to imagine the cumulative effect over a long period, and it's particularly difficult to compare different compound interest rates. This is why we tend to underestimate qualitative companies.

Quality of growth, the key to long-term success

I therefore invite you to focus on the quality of growth, i.e. (1) a company's ability to generate a high return on its capital employed, (2) its ability to generate a high return on its capital employed, and (3) its ability to generate a high return on its capital employed.on its capital employed, (2) its ability to maintain this profitability at high rates over the long term thanks to sustainable competitive advantages and significant underlying market potential, (3) its willingness to reinvest profits in growth with a long-term business vision, (4) and if possible while maintaining a certain financial solidity (low-leverage, self-financed growth).

And you'll see that while in the short term (< 1 year) valuation is an important factor that weighs heavily in the balance, in the long term (> 10 years), it's almost a drop in the bucket when it comes to the ultimate success of your investment.

The proof is in the BCG Analysis and Morgan Stanley Research study of the top quartile of best-performing S&P 500 stocks between 1990 and 2009. Over a 10-year period, earnings growth explains on average 89% of the rise in share price. Growth in multiples (P/E ratio in our example) accounts for just 6% over a 10-year period.

Now, I hope I've convinced you that if you're investing for the long term with a "buy and hold" strategy, the quality of the companies you invest in will determine your ultimate performance far more than the price you pay for them. Price is forgotten, quality remains.