[ARCHIVES] Michael Mauboussin: The Trouble with PE MultiplesVW Staff
Michael Mauboussin is considered an expert in the field of behavioral finance and has some famous books on the topic including, Think Twice: Harnessing the Power of Counterintuition and More More Than You Know: Finding Financial Wisdom in Unconventional Places.
From 2001 Michael Mauboussin: The Trouble with Earnings & PE Multiples
Michael Mauboussin: The Trouble with Earnings & PE Multiples
Wall Street is a world filled with rules of thumb and shortcuts. And while the objective of these shortcuts is to save time—ostensibly to improve investment performance – they are fraught with severe and crippling shortcomings.
The core of expectations investing is to correctly anticipate changes in the market’s implied expectations for a company’s long-term cash flows. The evidence notwithstanding, the investment community’s focus on short-term earnings and price/earnings is ubiquitous. In light of this, we address the following questions:
- How do we know the market is long-term oriented?
- Why do investors focus on earnings?
- Why are earnings unreliably linked to stock price?
- How is the earnings expectations game played and why should you avoid it?
- What are the shortcomings of the most widely used performance and investment yardsticks—return on equity (ROE) and the price/earnings (P/E) multiple.
Michael Mauboussin: The market takes the long view
Expected long-term cash flows, discounted by the cost of capital—not reported earnings—determine stock prices. How do we know this? The most direct evidence comes from stock prices themselves: we can estimate the expected level and duration of cash flows that today’s price implies.
One way to measure the market’s time horizon is to see how much value is attributable to dividends, say, over the next five years. As it turns out, we can only attribute about ten-fifteen percent of the stock price of the Dow Jones Industrial companies to expected dividends over the next five years.1 The percentage is likely to be even lower for broader indices that include many companies that pay no dividends. In either case, it takes many years of dividends to justify the current stock price.
Another way to assess the market’s implied time horizon is to estimate the number of years of value-creating discounted free cash flow it takes to justify the current stock price. This period, which we call the market-implied forecast period, can exceed twenty or more years for companies that demonstrate formidable competitive advantages. We find that the market-implied forecast period for U.S. stocks clusters between ten and fifteen years—once again, an indication that the market has a long, not short, horizon.
A less direct way to understand the stock market’s long-term orientation is to compare an investment in stocks with an investment in government bonds. As we write this in July 2001, the average dividend yield is about 1 percent. An investment in 30-year bonds yields in the neighborhood of 6 percent. Why would rational investors ever buy stocks when they can realize substantially higher current yields by buying less risky bonds?
While the investor’s primary interest is in stock price appreciation rather than in dividends, both depend on future cash flows. The long-term dividend growth rate of the Standard & Poor’s 500 stocks is approximately 6 percent. At that rate, it takes just over thirty years for the current 1-percent dividend yield to reach the bond yield of 6 percent.
The yield difference between stocks and bonds tells us the long-term cash flow growth prospects of companies are enough to compensate for today’s lower yield. Surprisingly, many executives and investors persist in the belief that the stock market has a short time horizon. Doug Geoga, president of Hyatt Hotels, expresses the mainstream view:
“Wall Street has a tendency to overemphasize short-term benefits at the expense of long-term benefits. . . . There is a reward given to pursue short-term actions that provide a short-term benefit at the expense of long-term value to your company.”
How can so many investors and managers continue to believe that short-term reported earnings rather long-term cash flows fuel stock prices? There are three plausible explanations. The first is that market participants misinterpret the stock market’s response to earnings announcements. The second is that the stocks of businesses with great long-term prospects do not always perform well. The final explanation is that portfolio managers have short (and shortening) holding periods. We will look at each of these explanations.