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Why bad multiples happen to good companies


Earnings multiples, particularly the price-to-earnings (P/E) ratio, are a common shorthand for summarizing how the stock market values a company. The media often use them for quick comparisons between companies. Investors and analysts use them when talking about how they value companies.
That there are generally more detailed models behind the shorthand seldom makes the headlines, and this contributes to a problem: executives who worry that their multiple should be higher than the one the market currently awards them. “We have great growth plans,” they say, or “We’re the best company in the industry, so we should have a substantially higher earnings multiple.” Their logic isn’t necessarily wrong. Finance theory does suggest that companies with higher expected growth and returns on capital should have higher multiples. And the theory held true when we analyzed large samples of companies across the economy.
However, within mature industries, our analysis showed that regardless of performance, multiples vary little among true peers. Companies may occasionally outperform their competitors, but industry-wide trends show a convergence of growth and returns that is so striking as to make it difficult for investors, on average, to predict which companies will do so. As a result, a company’s multiples are largely uncontrollable. Managers would be better off focusing instead on growth and return on capital, which they can influence. Doing so will improve the company’s share price, even if it doesn’t result in a multiple higher than those of its peers.

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Talk about the land of confusion. The VIX is at eight-year lows, despite a slew of geopolitical concerns. Stocks are at record highs. Spanish debt yields less than Treasurys.
How, then, is one of the world's biggest investors navigating this market?
Dan Morris is global investment strategist at TIAA-CREF, the asset management company with $569 billion in assets under management, sat down with Talking Numbers for an exclusive interview.

The Low VIX

"A very low reading on the VIX is kind of reflecting on the relatively benign environment for equities generally," Morris said. "We think it's too low, just if you look at the historical numbers. It's going to go up but not in a way that we see as really threatening at all."

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"Even if the VIX does go up [and] even if we do get some type of correction," added Morris, "the market has been a bit too smooth. If you look at the lo…