One of the most non-intuitive concepts for a value investor to understand is that a business with a high valuation is not inherently overpriced. A great business should have a high valuation because its earnings will grow into its high price.
An Example:
| Business A | Business B | |||||||
|---|---|---|---|---|---|---|---|---|
| Year | A Earnings | A Price | A P/E | A Growth | B Earnings | B Price | B P/E | B Growth |
| 1 | $1,000 | $10,000 | 10x | 5% | $1,000 | $20,000 | 20x | 30% |
| 2 | $1,050 | $10,000 | 9.5x | 5% | $1,300 | $20,000 | 15.4x | 30% |
| 3 | $1,103 | $10,000 | 9x | 5% | $1,690 | $20,000 | 11.8x | 30% |
| 4 | $1,158 | $10,000 | 8.6x | 5% | $2,197 | $20,000 | 9.1x | 30% |
| 5 | $1,216 | $10,000 | 8.2x | — | $2,856 | $20,000 | 7.0x | — |
Of course, price is likely to fluctuate in the meantime, possibly materially, but in this simple example, within 5 years, the high growth business has comfortably grown into its early valuation so that the two businesses are now similarly valued by P/E. Business B however, likely also has much more runway and better long term economic prospects, making it the better long term investment in year 1, despite the higher valuation.
This is not to go against the idea of value investing. In fact, it fits perfectly within the framework. The investor still cannot overpay. A high multiple paid for growth that never arrives is simply a bad investment.
Had Business B grown at 5% rather than 30%, its Year 5 P/E would still be over 16x, and the investor would have paid twice the entry price for an inferior outcome.
The framework does not change; only the required understanding of what one is paying for. However, it should also be understood that great businesses deserve higher valuations. If an investor relies only on low earning multiples to assess “value”, they should not be surprised in the future to find that many businesses they passed on have outperformed those who once appeared cheaper.
Connections
Link Explanation: The note linked above features a discussion surrounding the failings of the P/E ratio based on its inability to consider the quality of earnings. The current note discusses another issue inherent in the P/E, in that it does not factor growth into the metric. So while valuation of a business via the P/E can be useful, it is not appropriate as a basis for decision making alone.