Background Traditional corporate finance teaches us that the value of a security is equal to the present value of all future cash flows. In this statement there are two primary components— an implied discount rate (to perform a present value calculation) and an expectation of future cash flows. This is represented in the Dividend Discount Model:
P = Price D1 = Dividend r = Discount Rate g = Long-term Growth Rate
When we think about stock prices, we can structure it similarly:
Price = Expected Cash Flows / ( Discount Rate - Long-term Growth Rate )
The second part of this equation, ( Discount Rate - Long-term Growth Rate ) is captured, in short-hand, by a multiple. These multiples, such as Price-to-Earnings, Price-to-Sales, EV-to-EBITDA, etc., capture the more systematic aspects of pricing which is why they are useful for comparisons. While most investors are aware of these multiples and can calculate them, the drivers of a multiple are less known.
We’ll focus on the Price-to-Earnings multiple here, but the conclusions can be used across different types of multiples.
Practical notes on multiples: (1) Practitioners prefer using 1-yr or 2-yr forecasts of EPS (usually on a “next-twelve month basis” instead on a fiscal year basis) for P/E, (2) multiples are largely expected to be mean-reverting within the fiscal quarter, but drift in the opposite direction of interest rates
The drivers of the Price-to-Earnings multiple are changes to the discount rate and changes to the long-term growth rate. These relationships are time-varying, however, and are correlated to economic regimes.
For example, the relationship between the US 10year yield and the SPX P/E Multiple goes from -0.71 on a 5-year basis to -0.90 on a 2-year basis. This means that the importance of interest rates has increased in this time period.
SPX Forward P/E to US 10 Year Yields on a 5-year basis.
SPX Forward P/E to US 10 Year Yields on a 2-year basis.
When thinking about the macroeconomy, there are two major dimensions to consider: growth and policy. These dimensions impact multiples by expanding or contracting them. During periods of moderation, multiples will revert and investors should expect higher levels of volatility. This is because investors have to reposition from an accelerating regime to a situation where a shift in growth (from expansion to contraction or vice versa) may occur.
Equity multiples can be very useful tools for investors when evaluating an investment opportunity or their portfolio. By breaking down prices into the earnings (cash flow) and multiples (discount rate and long-term growth rate) component, and developing a view on both independently, we believe that investors can improve their expectations for markets and prices.