Are you applying the wrong valuation currency?
Prices are set by the marginal buyer, while financial markets establish conformity around valuation currencies that encourage buying, which in turn stimulates more borrowing and therefore more ‘moolah’ for those that dominate these markets. The latter obscures the ‘real’ price that is being paid by the former, which is why they need tools such as the GrowthRater to show what is actually being implied by current valuations by looking behind these distortions.
You are no more likely to see a bank discouraging debt as to find a brewer preaching temperance, so you shouldn’t therefore be surprised that the entire edifice from bank funded academia to bank analysts conform to valuation approaches that encourage debt-funded asset purchases. Equity sales desks are packed full of share-pushers who are wedded to post-interest based valuation metrics such as the venerable price earnings ratio (PER), while business schools pop out regiments of graduates believing in ‘weighting’ (aka discounting) their capital costs by what are often temporarily lower interest funding costs in WACC. Get access to cheap debt and there are few assets that will not yield an immediate marginal return over interest charges. Buy an average company and a corporate buyer might expect a 7% gross yield against debt servicing rates several percentage points below this, to provide an immediate kicker to profits. Include the tax shield and the accretion to earnings is even greater. Buy a mature business and the initial return rises even more. Max out the credit to buy more and one can generate some quite impressive rates of earnings growth that can then be sold to gullible markets as justifying a premium ‘earnings’ rating. Markets are full of companies pursuing acquisition growth strategies which command premium earnings ‘growth’ valuation multiples, notwithstanding this is merely disguising low rates of organic growth and value added. This however, is to conflate earnings accretion for value enhancement and is merely a carry trade. As with most carry trades, it reflects an asymmetric balance of risk and return between buy and sell and in this case a misunderstanding that debt doesn’t carriy a risk premium over and above its initial interest costs (Modigliani & Miller). Stop the merry-go-round however, and these stocks are highly vulnerable; not only as the low underlying growth exposed, but from the elimination of ongoing synergy benefits.
Without fresh meat to feed this monster, it’s not just that the low organic growth of the rump is exposed, but the cost synergies and displaced internal investments that had been supporting margins also disappear. As these groups have already maxed out on financial leverage, there is nowhere to hide and even if markets have oversold their stock, they are unable to buy in their own equity. When the marginal buyer has left the market, then valuations will collapse to what may even seem irrational levels, so caveat emptor.
My advice into an end of cycle market?
- Don’t just rely on consensus opinions on earnings or traditional post interest valuation metrics
- Appreciate that forecasts are not just likely to be wrong, but the extent of this error
- For this, check out the underlying margin of error on revenues and GrowthRating
- Apply this ‘margin of error’ data on revenues in the ‘Sensitivity’ analysis tool to remodel the target valuation and see it is still cheap on a lower revenue range.
- Avoid stocks running an implied GrowthRating ahead of both immediate and trend growth rates in organic sales.
- Avoid cyclically sensitive stocks, and with high WYT valuation volatility (scores), carrying high financial leverage.
All this ought to seem like simple common sense, but the number of stocks out there riding high on acquisition based growth and questionable accounting practices is shocking. What may be more shocking for some however, is the speed of derating once markets get wind that the party is over. Consistently outperforming the market is tough, which is why most hedge funds fail on this metric (60-80%: varying by period and survey). The future is inherently uncertain as are trading forecasts; management can execute a strategy poorly or dishonestly, while macro events can de-rail the best of plans. This is no excuse however, for being ignorant of how markets have been pricing growth into a stock or the potential margin of error on trading and valuation outcomes. The GrowthRater won’t tell you whether events such as a tariff dispute ends up into a global recession or worse, but it will help you model the potential impact on the relative stock price from your chosen scenario.