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22 July 2020

This document is directed at investment professionals and qualified investors (as defined by MiFID/FCA regulations).

In the media and the investment marketplace, we often hear about “valuations.” The statistics quoted are invariably multiples of earnings, sales or a similar measure.

These figures are often invoked to support a bullish or bearish thesis. But are these metrics meaningful? They may be insightful for the market in aggregate, but for growth companies and particularly for small growth companies, they can be misleading. We argue that returns for these kinds of companies are driven much more by fundamentals than shorthand valuation metrics.

Lazy Valuations

What passes for “valuation” on factsheets and investor commentaries is nothing more than an abbreviated version of real analysis. The intrinsic value of a stock is the net present value of all its future cash flows. Shorthand valuation metrics like price-to-earnings (P/E) have major drawbacks. First and foremost, they are static and only look at a snapshot in time. For mature companies that don’t grow, that may be just fine, but for small and medium-sized high-growth companies, P/E multiples are often inflated as companies grow in step-functions. Concur, which provides expense management, travel and invoice software, is an example. In the decade before it was bought by SAP, its average P/E was over 50x, but that turned out to be justified as its earnings per share quadrupled, driving a 30% annualized return in its stock price.

Second, valuation metrics should and do vary widely based on the quality of the businesses. We define quality as the level and sustainability of the return on invested capital that businesses may generate. The former is impacted by a company’s value proposition to its customers and its business model while the latter is driven by competitive advantage.

Lastly, the amount of debt a company has may dramatically impact a metric like P/E as investors pay less for more highly leveraged companies because of heightened risk, all else being equal.

In addition to being impacted by growth, quality and risk, P/E multiples are also impacted by accounting. Growth companies recognize a much greater proportion of their investment for the future in the income statement than old-economy companies. This is because investment in intangible assets like research and development on software algorithms or new drugs are expensed, serving to depress earnings. By contrast, investments in tangible assets like property or plant and equipment are capitalized and hit income slowly over time.

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