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.