Why valuation matters….

Why valuation matters…..

It must be a year ago, I wrote a substack called “Price to Sales is Dead!”  My intention was to highlight how random and large p/s ratios that were being bandied about were a bubble absent extreme confidence in the sustainable sales growth rate and the terminal operating margin.  The purpose of p/s is to compare business models and their ultimate profitability down the road to form a valuation based on…..P/E and cash flow!  To this day, the sell-side analysts continue to make up price targets using p/s claiming premiums are warranted for their favorites which are nothing more than find a target and work back to a p/s that seems “defensible”.  THE KEY FACTOR in price to sales is discounting back the cash flows in the outer years.  Interest rates are THE KEY FACTOR in the discount rate.  Starting to see my point?  A stock valued on price to sales at 1.5% interest rates is very different when the interest rate pops to 4% plus.  We will save DCF (discounted cash flow) discussions for a later date or let you Google how it works.  Let’s keep going.

So, higher interest rates are a wowser on valuations for stocks where the value (cash flow) is expected many years out.  It is also important for P/E multiples, the more commonly used way of valuing stocks and the overall market.  I went thru this exercise in the original write-up, but let’s do it again.  Consider the appropriate P/E ratio to be an inverse of interest rates, adjusted for risk associated with their earnings. Or alternatively, take the inverse of the P/E on a stock and convert it into an earnings yield.  With a stock at 20x earnings, the investor is getting a 1/20 or 5% earnings yield on their investment.  This means, all things equal, you find the consistency of the earnings to be strong and predictable and you are “earning” 5% by owning the stock and participating in its growth ahead.  At 10x earnings, you are getting a 10% earnings yield, which likely means investors aren’t very confident in the trajectory or the business is cyclical and has good years and bad ones.  At 30x earnings P/E, you are getting a 3.33% yield which is far more risky, but the market is saying it has confidence in the growth of the E going forward.  That’s P/E!  Imagine the multiplicative effect of this when you use P/S because the E is years out.