What many investors still don't understand about P/E ratios
P/E is actually a simplified discounted cash flow (DCF) valuation
Photo of Aswath Damodaran via Wikimedia Commons
Summary
When we apply a P/E multiple to a stock, we are essentially performing a DCF valuation with specific assumptions on growth and required rate of return.
Aswath Damodaran differentiates between valuation and pricing. Valuation is absolute while pricing is relative.
However, new students often wrongly assume that multiples meant pricing, and that it is inferior.
The NTM P/E ratio is a simplified discounted cash flow (DCF) valuation.
Background
Is Damodaran wrong?
New students of Aswath Damodaran, a finance professor at NYU, like to differentiate valuation and pricing.
They say valuation means discounted cash flow (DCF) calculations. Using P/E multiples is pricing, not valuation.
In this post, I will show that the difference is artificial.
P/E is actually a simplified DCF.
What do you mean by P/E is a simplified DCF valuation?
Let’s start from the basics.
What is P/E?
We talked about this before. P/E is calculated by dividing share price by its earnings per share (EPS). P/E of 15 times means shareholders are paying $15 for every $1 of profits earned by the company.
That’s great. You still remember.
How about DCF?
A share is worth the cash the shareholder is expected to receive in the future, discounted back to today’s value. Future cash should be discounted because $1 ten years from now is worth less than $1 today.
That’s the essence of DCF valuation.
Very good.
What is a share worth if its cash payouts grow at a steady rate forever?
You’re talking about the Gordon Growth Model. Here’s the equation:
For simplicity, let’s assume earnings convert completely into free cash flow (FCF = earnings).
Rewrite your equation using these assumptions. You can use abbreviations now.
Sure. I will use ke to represent required rate of return for equity holders, P for value of a share today, E1 for next twelve months (NTM) EPS and g for growth.
Great. Divide both sides by E1.
What are you trying to get at? Just tell me the point already.
This is the final step.
After this, you’ll see the complete picture.
Ok. Here’s the final equation.
Let’s call this equation, “NTM P/E is simplified DCF”.
On the left-hand side, we have the NTM P/E ratio. Many investors like to use this. Essentially, this ratio is saying, “what is the value of every $1 of future earnings, today?”
What’s on the right-hand side?
That’s a variation of Gordon Growth Model. It is saying, “what is the value of every $1 of future earnings, today?”
Now we have it.
NTM P/E is actually a simplified DCF!
Hmmmm… I am still trying to process this. Do you have an example?
Sure.
I created an example in the Excel file below.
First, I calculated the value of a share using DCF valuation. I assumed 3% growth rate and 10% required rate of return.
Based on the DCF valuation, the value of a share today is $14.71. NTM EPS is $1.03.
The NTM P/E implied by the DCF valuation is 14x.
Ok.
Next, I used the “NTM P/E is simplified DCF” equation. Given 3% growth rate and 10% required rate of return, the shares should trade at 14x NTM P/E.
This is the same P/E implied by the DCF valuation.
The upshot is that whenever we slap a 14x P/E on a share, we are actually performing a simplified DCF valuation with 3% growth rate and 10% required rate of return.
NTM P/E is simplified DCF.
This makes more sense now. So, Damodaran is wrong?
Aswath Damodaran is not wrong. He already knows this.
For example, in pages 758 and 760 of his paper from 2005, he derived similar equations.1
Then why does Damodaran say that multiples and DCF are different?
Damodaran never said that.
He only said that valuation is different from pricing.
Valuation is determining an asset’s intrinsic value based on its underlying fundamentals. This is different from pricing, which is based on what other market participants are willing to pay for similar assets.
Since most assets derive their intrinsic value from their cash flows, DCF is the most common way to value assets.
Multiples are the most common way to price assets. Comparing P/E ratios is a quick way to gauge how expensive or cheap a company is, relative to other companies.
Essentially, valuation is absolute. Pricing is relative.
However, new students often misunderstand Damodaran. They wrongly assume that multiples meant pricing, and that it is inferior. In fact, P/E ratio is a simplified DCF.
I see. But there’s still one thing bothering me. Your key assumption is not realistic. Earnings usually do not convert 100% into FCF.
You’re right.
Because of capex and investments in working capital like inventories, a company can report $100 mn of earnings but only $50 mn of FCF.
Long story short, all else equal, a company with higher capital intensity will naturally trade at a lower NTM P/E.
I alluded to this in one of my earlier posts: The lower the P/E, the better… really?
Can you explain in more detail how capital intensity influences a company’s NTM P/E?
Let me do that in a future post.
I will also try to explain why capital-light businesses like software may be a bargain at 15x NTM P/E, but capital-intensive businesses like telecommunication may be overpriced at the same 15x NTM P/E.
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Published by Andrew Wong, ACA, CFA
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