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Going to play a little Devil’s Advocate.
I really hate macro explanations for high multiples like low interest rates. But there might be a business case for structurally higher multiples...
Not sure how much I believe this, but let’s check it out
I really hate macro explanations for high multiples like low interest rates. But there might be a business case for structurally higher multiples...
Not sure how much I believe this, but let’s check it out
1/
There are two key assumptions here:
1. Companies need to make investments to grow. These investments can take different forms.
2. On average, investors are pretty good at determining the returns on these investments
There are two key assumptions here:
1. Companies need to make investments to grow. These investments can take different forms.
2. On average, investors are pretty good at determining the returns on these investments
2/
The average ROE of a public corporation is 10-12% and the average reinvestment rate for the S&P 500 is ~70%. This implies earnings growth of 7-8%.
Basically, the multiple is just a shorthand for a DCF of all corporations growing at this rate...
The average ROE of a public corporation is 10-12% and the average reinvestment rate for the S&P 500 is ~70%. This implies earnings growth of 7-8%.
Basically, the multiple is just a shorthand for a DCF of all corporations growing at this rate...
3/
This growth is determined by two factors: the reinvestment rate and the ROE (the return on that investment).
Obviously, the economy has changed a lot over the last 100 years. With it, the NATURE of investments and their returns have changed too.
This growth is determined by two factors: the reinvestment rate and the ROE (the return on that investment).
Obviously, the economy has changed a lot over the last 100 years. With it, the NATURE of investments and their returns have changed too.
4/
In the past, a department store had to build a new store, pay rent and upstart costs, hire new employees, add factories, etc. to grow.
All of these investments required lots of capital. Naturally, if companies expenses this capital immediately, they would be loss-making
In the past, a department store had to build a new store, pay rent and upstart costs, hire new employees, add factories, etc. to grow.
All of these investments required lots of capital. Naturally, if companies expenses this capital immediately, they would be loss-making
5/
You can see where I’m going with this. To counter this, accountants made up GAAP rules which allowed companies to capitalize capex, certain start up costs and even rent.
The goal was to make the accounting ROE mirror the economic ROE of these investments.
You can see where I’m going with this. To counter this, accountants made up GAAP rules which allowed companies to capitalize capex, certain start up costs and even rent.
The goal was to make the accounting ROE mirror the economic ROE of these investments.
6/
And it worked. If a $1m factory was expected to generate $200k run-rate profit, then this 20% economic return would be reflected by a simple incremental margin calculation.
Assets up $1m
Operating profit up $200k
Incremental ROA: 20%
And it worked. If a $1m factory was expected to generate $200k run-rate profit, then this 20% economic return would be reflected by a simple incremental margin calculation.
Assets up $1m
Operating profit up $200k
Incremental ROA: 20%
7/
This process worked perfectly for these “old style” investments.
But technological change is faster than changes in these GAAP rules...
The “new wave” of investments consist of R&D, search marketing, web/software development, etc.
This process worked perfectly for these “old style” investments.
But technological change is faster than changes in these GAAP rules...
The “new wave” of investments consist of R&D, search marketing, web/software development, etc.
8/
These investments are economically identical to any other asset - they’re expenses now that will provide future value. But not under GAAP.
With a few exceptions, most of these costs are to be expensed immediately.
These investments are economically identical to any other asset - they’re expenses now that will provide future value. But not under GAAP.
With a few exceptions, most of these costs are to be expensed immediately.
9/
R&D costs for 2025 airplane engines are expensed today
Search advertising that will generate recurring business is all expensed today
The salaries of customer service reps that can handle 10x the business are expensed today
The list goes on...
R&D costs for 2025 airplane engines are expensed today
Search advertising that will generate recurring business is all expensed today
The salaries of customer service reps that can handle 10x the business are expensed today
The list goes on...
10/
Simply because GAAP rules haven’t evolved to accommodate these new wave investments, growing companies now have structurally lower earnings coupled with higher reinvestment rates.
In other words, today’s S&P earnings are structurally lower than “earnings ex investments”...
Simply because GAAP rules haven’t evolved to accommodate these new wave investments, growing companies now have structurally lower earnings coupled with higher reinvestment rates.
In other words, today’s S&P earnings are structurally lower than “earnings ex investments”...
11/
To a significant degree!
To compensate for this, the investor community has applied a higher multiple on reported earnings.
While the “implied multiple” on so-called “earnings less investments” may not have changed much.
To a significant degree!
To compensate for this, the investor community has applied a higher multiple on reported earnings.
While the “implied multiple” on so-called “earnings less investments” may not have changed much.
12/
As this occurs to a larger degree, the discrepancy between economic ROE and accounting ROE will widen further, rendering the multiple even more meaningless.
As this occurs to a larger degree, the discrepancy between economic ROE and accounting ROE will widen further, rendering the multiple even more meaningless.
13/
While I do not fully endorse such a change, perhaps a change in GAAP rules giving companies more leeway to capitalize costs that are really investments might lead to a decline in the average multiple.
While I do not fully endorse such a change, perhaps a change in GAAP rules giving companies more leeway to capitalize costs that are really investments might lead to a decline in the average multiple.
14/
Not sure if I completely agree with this, but I do think it’s a *valid* theory and one that doesn’t rely on macro factors like low rates that are often thrown around as justification for high multiples.
Not sure if I completely agree with this, but I do think it’s a *valid* theory and one that doesn’t rely on macro factors like low rates that are often thrown around as justification for high multiples.
