One of my investing email’s founding principles is that most people shouldn’t bother with stock picking. The payoff isn’t worth the effort. To consistently make money from it you’d have to be among the top, I don’t know, five per cent of stock pickers in the world.

Another of the email’s founding principles is that investing is fun! Even if you don’t want to dedicate yourself to the pursuit of alpha, I say investing is worth learning about just for one’s own edification. 

Plus, investing isn’t just something that happens in your brokerage account. Investing goes on all around us, all the time. Knowing a bit about investing helps you understand what’s going on. It makes sense of why companies do what they do, and how business people think.

That’s why, starting this week, I’m getting into the weeds. A guy called Michael Mauboussin teaches a famous security analysis class at Columbia University in New York. I’m going to take topics from the reading list and walk readers through them. 

Obviously, high-end securities analysis as taught in Columbia University isn’t always clear and straightforward. There are parts I’ll gloss over, and parts that might be a bit dense. But bear with me. I’ll make it as intelligible as I can. 

I’ll start with the topic of valuation. It’s a big one. Valuation is something that matters to everyone from hedge fund principals to home buyers. And every corporate M&A deal you see is basically a story about valuation.

Today I’m going to look at stock valuation.

Often, you hear stocks get talked about in terms of price to earnings multiples — like ICON has acquired PRA Health Sciences at a multiple of 35 times 2021 earnings. Or you may have heard stock market multiples are close to their all-time high. This means companies are expensive relative to the amount of profit they make. 

The p/e multiple is the relationship between price and earnings.  So if the multiple drops by half, for a given amount of earnings that means the company is worth half as much. 

So what goes into a p/e multiple? There are basically four ingredients. The first is earnings growth. The second is the cost of capital — the minimum return an investor requires in order to give the company money. The third is return on incremental invested capital (ROIIC). ROIIC is like a car’s fuel efficiency. It measures how well a company turns invested money into profits. The fourth is the discount rate, or “how much you prefer money now to money in future”.

When you buy a stock, you’re buying a share of a company in the here-and-now, and also its future potential. So in valuing it, it’s helpful to ask two questions: what is it? And what will it become?

The first step is to value it in its steady state, when it’s just chugging along without any growth. Then, you can add in its potential for growth. 

To do this, all you need is cost of equity capital. That is, what return are investors expecting when they put equity into the company? And to know that, you just need to know what the going rate is in the market. If investors in the market can get an eight per cent return for an equity investment in another similarly-risky company, then the company’s cost of equity is eight per cent. 

To turn that eight per cent number into a multiple, all you do is divide 1 by it. So 1 / 0.08 = 12.5. An investor will pay a multiple of 12.5 for a stable company when the cost of equity is eight per cent. 

The next step is to add in growth. Growth matters a lot to a company’s multiple, and valuation. That’s because valuation models are trying to get at how valuable a company will be in the distant future. Growth compounds on itself, so a small change in the growth rate of earnings can translate into a very different company in 20 years’ time. And hence, a very different multiple. 

Mauboussin takes the example of a company with a given cost of capital and  ROIIC. Forecasting ten per cent growth in earnings, its p/e multiple is 32. 

Then he takes the same company, with the same cost of capital, and the same ROIIC – but assumes seven per cent growth in earnings. That company now has a p/e multiple of 25. 

In other words a company whose forecast next-year earnings are only 2.7 per cent lower than in the scenario where they grow by 10 per cent… translates to a multiple that’s 23 per cent lower. That subtle change in the trajectory of earnings makes the company almost a quarter less valuable. 

This hints at why many loss-making technology companies are valued in the tens of billions. It’s because, in the long run, the trajectory of earnings matters much more than their level. For example a software company called UiPath floated on the New York Stock Exchange last week, at a valuation of $41 billion, despite losing $519 million in 2020. It’s forecast to lose $94 million next year. The level of UiPath’s profits might be bad, but the trajectory is excellent.

The next factor is return on incremental invested capital, or ROIIC. This number shows how efficient a company is at generating profits. It shows how much investment it takes for a company to generate a given amount of profit growth.

In other words, profit isn’t enough on its own. Many studies have shown that around 50-60 per cent of mergers make shareholders worse off. That’s despite growing the acquiring firm’s profits. Why do they make shareholders worse off? Because the failed acquisitions grow ROIIC less than the cost of capital. 

This is why I, and others, get so het up about Irish banks’ low profitability. The Irish banks are making many millions in profit. But their profits, expressed as a percentage of equity capital, are less than their percentage cost of equity. So they’re wasting away, unable to attract equity funding from the market.

The market loves technology companies because they tend to be capital efficient. Technology — along with pharmaceuticals and advertising — has some of the highest ROIC of any industry, according to NYU Stern. 

Capital efficiency comes from being able to consistently generate profits on investments. Firms with high ROIC/ROIIC tend to have moats that stop competitors from coming in and undercutting their margins (think patented drugs, or branded deodorant). They also tend to be in industries that don’t require a lot of investment. The firms with the lowest ROIC/ROIIC are in industries that require a lot of investment, and which also are highly competitive — like property development. 

Here’s how different levels of ROIIC feed into p/e multiples.

Having considered the cost of capital, the growth of earnings and the ROIIC, the last element of valuation is the discount rate. 

The discount rate isn’t about estimating how much money the company will make. It’s about the question of how you value a future benefit in the here and now. That’s because a benefit now is more useful than the same benefit years in the future. The discount rate is a measure of how much earnings in the here-and-now are preferred to earnings in the future. 

The number itself is similar to the cost of capital. It’s all about opportunity cost — what else could I be doing with this money? It comes from the risk free rate on government bonds, plus the premium that investors demand for the risk of holding stocks. The better things are at present, the more opportunities there are lying around, the more you want the money now, and the higher the discount rate.

You may have seen that the risk free rate, the one on US government bonds, has been falling in recent times. It’s been falling for almost forty years, in fact. A lower risk free rate means lower discount rates which means higher multiples and higher stock prices. They go in opposite directions. 

The principles of stock valuation apply more broadly than you might think: compounding matters a lot. Measure benefits in terms of the effort that goes into producing them. Think of things in terms of opportunity cost. And think carefully about what you’re willing to give up today for happiness in future.