Price and Value (eBook)

Table of Contents 5
About the Author 10
About the Technical Reviewer 11
Acknowledgments 12
Preface 13
Introduction 18
Chapter 1: The Ford Dollar: The Mysterious Multiple 27
1.1 P/E As a Measure of How “Expensive” a Company Is 30
1.2 P/E As a Predictor of Future Share Price 32
1.3 P/E As a Predictor of Future Returns 35
1.4 The Mysterious Multiple 42
Chapter 2: The Value Triangle 44
2.1 Accounting Valuations: The Limitations of “Book Value” 45
2.2 The Shortcomings of Financial Models 50
2.3 The Pros and Cons of Market-Based Valuation Metrics 55
2.3.1 Disney vs. Netflix 56
2.3.2 Ford vs. Tesla 58
2.4 Triangulating Intrinsic Value: The Use of Valuation Ratios 61
2.4.1 Price-to-Book 62
2.4.2 Return-on-Assets 63
2.4.3 Price-to-Earnings 64
2.5 Summary 65
Chapter 3: Valuation Ratios 66
3.1 Trailing P/E, or P/Ettm 67
3.2 Forward P/E 69
3.2.1 PER (Relative P/E) 74
3.2.2 Normalized P/E 74
3.2.3 Improving on P/E? 75
3.3 Price-to-Operating Earnings 75
3.3.1 Pro Forma Earnings 79
3.3.2 Core Earnings 82
3.4 Dividends 84
3.4.1 Dividend Ratios: Significance and Trends 85
3.5 Price-to-Sales 90
3.6 Metrics Based on Cash Flow 99
3.6.1 EBITDA and EV/EBITDA 100
3.6.2 Free Cash Flow 101
3.6.3 Do Cash Flow Metrics Improve Upon Earnings-Based Multiples? 103
3.7 Price-to-Book 108
3.8 Tobin’s Q 111
3.9 Return-on-Assets 113
3.10 Adjustments to the Denominator: Cyclically Adjusted P/E (CAPE1) 115
3.10.1 Critics and Critiques 119
3.10.1.1 Accounting Changes 119
3.10.1.2 Dominance of Large Losses by a Few Firms 120
3.10.2 CAPE Performance 121
3.10.3 CAPE: An Assessment 132
3.11 Adjustments to the Numerator: Cash-Adjusted P/E (CAPE2) 138
3.12 What About the PEG Ratio? 145
3.13 Composite P/E Ratios 148
3.14 Summary 151
Chapter 4: Interpretations: P/E As a Dependent Variable 155
4.1 What Does the P/E Really Measure? 156
4.2 Firm-Level Drivers 159
4.2.1 Growth 159
4.2.1.1 The Case for Growth 165
4.2.2 Profitability, and “Quality” 170
4.2.2.1 Gross Profit Metrics 172
4.2.2.2 Return on Equity 173
4.2.2.3 The “Quality” Factor 177
4.2.3 Size 180
4.2.4 “Risk” and Cost of Capital 183
4.2.5 Shareholder Return 186
4.2.5.1 Dividends 186
4.2.5.2 Buybacks 190
4.2.6 Strategy and Business Model Issues 192
4.2.6.1 Quality of Revenue 194
4.2.6.2 The Conglomerate Discount 199
4.2.6.3 Is there a Conglomerate Premium? 202
4.2.6.4 Capex Intensity 205
4.2.6.5 Excess Cash Accumulation 206
4.2.6.6 Exposure to the Business Cycle 207
4.2.7 Earnings Volatility 209
4.2.8 Share Price Volatility (Beta) 212
4.2.9 Leverage 218
4.2.10 Accounting Issues 225
4.2.11 Governance 226
4.3 Sector-Level and Market-Level Drivers 231
4.3.1 Sentiment (“Animal Spirits”) 231
4.3.1.1 The Market P/E and “Animal Spirits” 233
4.3.2 Sector Discounts and Premiums 236
4.3.3 Regulation 243
4.3.4 Monetary Policy 246
4.3.5 Fiscal Policy 250
4.3.6 Inflation 252
4.3.7 Interest Rates and Bond Yields 257
4.3.7.1 The “Fed Model” 258
4.3.7.2 The Interest Rate Level and the P/E: Is There a Sweet Spot? 260
4.3.8 International Differences 264
4.4 Summary 269
Chapter 5: Applications: P/E As an Independent Variable 272
5.1 Using Multiples to Forecast Stock Prices 273
5.1.1 The General Case: P/E As a Contrarian Indicator 273
5.2 Screening for “Value”10 279
5.2.1 Evidence for the Value Anomaly 280
5.2.2 Explanations of the Value Anomaly 284
5.2.2.1 Mean Reversion 284
5.2.2.2 “Value” As a “Risk Factor” 286
5.2.2.3 “Value” as a “Delayed Response” 289
5.2.2.4 Behavioral Finance Explanations 290
5.2.2.5 “Value” As a Reflection of a Learning Process 292
5.2.2.6 The “Cyclicals” Exception 293
5.2.2.7 Is “Value” Disappearing? 294
5.2.3 Comparing Multiples As Value Screens 296
5.2.3.1 Price/Book Is Ineffective 297
5.2.3.2 Cash Flow Multiples: Mixed Results 298
5.2.3.3 Dividend Yield vs. P/E 301
5.2.3.4 Does CAPE Improve Performance? 302
5.2.3.5 Market Regimes: Bull Markets Favor Growth over Value (As a Rule) 305
5.2.3.6 Multiples and Expected Returns: Summing Up 307
5.3 Index Construction 309
5.4 Factor Models and “Smart Beta” 311
5.4.1 The Proliferation of Factors 313
5.4.2 The “Value” Cornerstone 315
5.5 Valuing Corporate Transactions 316
5.5.1 Deal Pricing 316
5.5.2 Sum-of-the-Parts Analyses (the Conglomerate Discount) 319
5.6 Diagnosing Market Regimes 322
5.6.1 Monetary Policy Impact 323
5.6.2 Bubble Detection 327
5.6.3 Illuminating the “Fine Structure” of Market Regimes 331
5.7 Summary 337
Chapter 6: Assessments and Qualifications 339
6.1 The Best Metric Today (2019): The P/E 339
6.1.1 P/E Tends to Prevail (but Not Always), and It Only Explains So Much 341
6.1.2 Substituting Earnings Measures Other Than GAAP-Compliant Net Earnings Does Not Reliably Improve Performance (Yet) 342
6.1.2.1 Cash Flow Multiples are Promising 342
6.1.3 The Performance of All Multiples Is Highly Dependent on the Market Regime 342
6.1.4 The Performance of Some Multiples Has Diminished Significantly over Time 343
6.1.5 Sensitivity Varies, but Favors P/E 343
6.1.6 A Future Orientation Tends to Improve Short-Term Performance, but Only So Much 344
6.1.7 Prediction Tends to Improve Significantly as the Holding Period Increases 345
6.1.8 Cash Flow Multiples Are Less Reliable 346
6.1.9 Averaging (Trend-Smoothing) Multiples: An Under-explored Concept 346
6.1.10 P/E Wins the Industry Popularity Contest 346
6.2 Shifting Definitions 348
6.2.1 GAAP,13 Non-GAAP, Core, and So On: The Validity Problem for “Earnings” 349
6.2.2 Street Earnings 350
6.2.3 IFRS vs. GAAP 353
6.2.4 Changing Accounting Standards 354
6.2.5 Earnings Management 1: Gaming the Numbers 356
6.2.6 Earnings Management 2: Buybacks and EPS Enhancement 358
6.2.7 Cash Dilution (“Nonoperating Financial Assets”) 362
6.2.8 Taxes 363
6.2.9 The Effect of Asset-Light Business Models 365
6.2.10 The Effect of Alternate Growth Strategies: Acquisition vs. Internal Development 369
6.3 Problems with Price-to-Book 371
6.4 ROA: An Incomplete Picture 374
6.5 Concluding Comments: The Uncertainty Principle(s) in Finance 377
6.5.1 The Academic Confusion Factor 377
6.5.2 Reflexivity and the “Human Uncertainty Principle” 379
6.5.3 Fischer Black’s Proposition 382
6.5.4 Price-Insensitive Markets 385
Appendix A:A Critical Examination of Discounted Cash Flow Valuation Methods 387
The End of Book Value 387
Discounted Cash Flow Modeling: A Critical Assessment 391
The DCF Best Case 392
What Is DCF, Really? 393
Uncertainties, Compounded 394
DCF Manipulation 398
Is DCF Actually Used by Market Practitioners? 399
DCF: Assessments 400
Afterword:Fair Price, True Value 403
Index 406