Making sense of the multiples approach to valuing stocks

Published Wed, Apr 13 20223:13 PM EDTUpdated Thu, Apr 14 20228:27 AM EDT

During our April Monthly Meeting , we received a great question from one of our Investing Club members: How do you value stocks using the "multiples approach." While Jim Cramer provided some key insights, the topic is so important we wanted to circle back with a more detailed explanation and stock example to further clarify the concept of multiples for Investing Club members. The multiples approach is based on a simple idea: Similar types of businesses sell at similar prices. Applying the approach is also straightforward. Choose a financial metric and apply an appropriate multiple to determine a price target. 1. Select the financial metric Let's start with the choosing the metric. In most cases, we use earnings per share, as this metric represents the profit a company brings in after all expenses (including taxes and interest on debt) are paid out. Other financial metrics can also be applied, but it's important to understand that the farther up you move on the income statement, the farther you get from actual earnings the company can return to shareholders. For example, a company might seem a good bet based on its price-to-sales ratio, but that tells us nothing about the company's profits — or lack thereof - and therefore nothing in terms of its sustainability as a business. So why would we ever use a metric other than earnings per share? When a company's earnings are either too small to matter or non-existent, analysts and investors look for other metrics to provide insight into the potential earnings power at some point in the future. The two most widely used metrics outside of earnings are EBITDA (earnings before interest, taxes, depreciation, and amortization) and sales. EBITDA is useful because it can provide insight into the strength of a company's operating profitability before non-cash expenses. This helps generate a better apples-to-apples comparison across an industry to see which companies are more efficiently managing items above the EBITDA line, such as the cost of goods (COGS), SG & A (sales, general, and administrative costs), and R & D (research & development costs). Whichever metric you decide to use, the process is the same — study the potential investment opportunity, attempt to forecast some future result for the metric of choice, and apply an appropriate multiple to determine a price target. 2. Choose a multiple This brings us to the art of choosing an appropriate multiple — one that reflects the potential opportunity, growth rate, durability of sales and earnings, quality of management, strength of the balance sheet and any other factors material to our investment. First, we need a starting point. There are two ways to get there: Consider the multiple the stock has historically traded at Look at the multiple of similar companies Once we have determined a good starting point, we can start to ask ourselves what differences there may be today versus history (in the case of using a historical multiple to start) or the company's strengths and weaknesses compared to its peers (in the case of using a peer multiple to start) and adjust accordingly. 3. How the Club does it Consider the Investing Club's stake in Ford Motor (F). We recently revised our price target to reflect a share price of 11 times (the multiple) fiscal year 2022 earnings expectations (the financial metric). Historically — from early 2010 to late 2019 — shares traded as low as 5 times, and as high as 11 times, forward earnings estimates. This begs the question: If investors were only willing to pay 5 to 11 times earnings for that decade, why should we expect them to pay at the top end of this range going forward? It comes down to an analysis of what Ford looked like in the past and what it looks like now and in the future. In that past period, Ford was entirely focused on ICE (internal combustion engine) automobiles, had little services offerings to speak of, and operated in regions that weighed on the profitability of the company. Today, however, Ford is a company intensely focused on converting its lineup to EV (electric vehicles), is adding service offerings to its cars — including Ford+ and a recently signed deal with Salesforce (CRM) to launch VIIZR , a service built for those that use their Ford vehicles as an office on wheels — and has restructured operations in South America to improve the health and sustainability of the company. These actions have resulted in not an only improvement to profitability but also a diversification of sales streams to include more resilient recurring revenues. That's why we believe Ford is worth more versus its own historical valuation. In the case of Ford, we can also look at peer valuations, specifically the valuations being applied to electric vehicle makers. For this, we can keep it simple and focus on the leader in electric vehicles Tesla (TSLA). Based on a $1,000 share price and 2022 earnings expectations of $10.73 per share, we can calculate (1,000 divided by $10.73) that Tesla trades at roughly 93 times forward earnings. Given that Tesla is growing much faster than Ford and does not have to contend with a declining ICE business, the higher multiple on Tesla is warranted. We certainly are not saying that Ford deserves a Tesla-like multiple, however, we do believe it speaks to the higher multiple investors are willing to place on electric vehicle companies and therefore believe some multiple expansion is warranted as EVs grow into a larger share of sales for Ford. How much expansion is the art of choosing the right multiple. We will look at a quantitative way to adjust multiples for growth rates below when we discuss the "PEG ratio." 4. Multiples and interest rates The multiples approach can be used with any financial metric — a measure of sales, EBITDA, earnings, even cash flow – but understand that certain overlying factors will impact multiples across the board. The most direct influence is interest rates. When rates rise, multiples contract – especially higher multiples. There are two reasons for this: If the rate on debt instruments, most notably the 10-year Treasury, rise, the competition for equities increases. Given that Treasury notes are backed by the US government, many view the 10-year yield as the "risk free" rate. Therefore, if the return on a risk-free asset increases, then investors will demand a higher return on the risky asset. To achieve that higher return, they must get a better deal on the asset they are purchasing and therefore will look to pay a lower multiple. Higher multiples are generally placed on companies with more growth. Buying growth means that investors are paying today for earnings expected to be realized further out in the future. However, given that rates usually rise to reflect inflation expectations, the rise in rates means that investors will discount back the future earnings at a higher rate. In doing so, the present value of those future earnings declines, something we will discuss in more detail when we touch on discounted cash flow analysis. In addition to multiple compression in the face of rising rates, investors also increase their focus on profits available today. Again, this is due to the impact a higher discount rate can have on present values. As a result, not only will multiples be hit, but higher multiples will be hit harder. As we have seen over the past few months, multiples based on metrics other than earnings will also be slammed since we only revert to those multiples when earnings are lacking and as we just noted, when rates and inflation expectations rise, investors want earnings in the here and now. 5. Adjusting multiples for growth Investors can also attempt to adjust these multiples to account for future growth. The most common being the "PEG" ratio, which attempts to adjust the price-earnings ratio and account for growth. The thinking is that a higher p/e multiple on its own does not determine that a stock is more expensive because it fails to factor in future growth. Let's apply this thinking to our analysis of Ford and Tesla. As a reminder, we argued that Ford deserves a multiple of 11 times earnings and called out that Tesla (based on the numbers available at the time of this writing) trades at 79 times earnings. Now let's consider the growth rates. According to FactSet, Ford is expected to generate $2.83 in earnings per share by calendar year (CY) 2025 while Tesla is expected to generate $19.85 per share. Using CY2021 as a starting point, this amounts to a 4-year compounded annual growth rate of 15.5% for Ford and 30.8% for Tesla. We can now take these growth estimates and apply them to our earnings multiple to normalize the valuations for expected growth as follows (recall, we called out an 11 times target multiple for Ford and a 93 times current multiple for electric vehicle peer Tesla — these numbers are the numerator in our PEG ratio equation): Ford: 11/15.5 = 0.71 P/E/G ratio Tesla: 93/30.8 = 3.02 P/E/G ratio What this tells us is that while we already knew that Ford is and would remain (if it hits our target multiple-based valuation) far cheaper on an absolute price-to-earnings basis (11 times versus 93 times) it is also significantly cheaper than Tesla even after we factor in Tesla's materially higher growth rate — by about a third of the valuation. Bottom line While there are many ways to approach valuation — and we plan to address those in the future — the multiples-based approach is by far the most broadly used method for valuing stocks and arguably the most important method to understand when navigating this difficult market. When investors say that higher rates are causing "multiple contraction," they are referring to the multiple placed on a given financial metric. Even if there is no change to earnings expectations, when the cost of capital (think rates) increases, investors are simply not willing to pay the same multiple that they were in a lower rate environment. If rates are not the focus and earnings are revised, understanding this approach explains the impact on the stock price as the multiple is placed on a different number. But we must be mindful that the multiple investors are willing to pay is often going to change as well when numbers are revised because the new numbers themselves will impact investor sentiment. (Jim Cramer's Charitable Trust is long F. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

Jim Cramer on CNBC's Halftime Report.

Scott Mlyn | CNBC

The multiples approach is based on a simple idea: Similar types of businesses sell at similar prices. Applying the approach is also straightforward. Choose a financial metric and apply an appropriate multiple to determine a price target.