Why valuation multiples can be 'useless' in assessing ASX shares: expert

Even though Amazon stocks were 'expensive' in 2006, you could have paid double and it still would be a 57-bagger today.

| More on:
sad, dejected person looking at document with laptop and cup of tea nearby

Image source: Getty Images

You’re reading a free article with opinions that may differ from The Motley Fool’s Premium Investing Services. Become a Motley Fool member today to get instant access to our top analyst recommendations, in-depth research, investing resources, and more. Learn More

How do you know whether an ASX share is expensive, cheap or otherwise?

A regularly used tool is to calculate the valuation multiple. This is seeing how a specific financial metric compares to the share price.

The traditional one is the price-to-earnings (PE) ratio. But there are also price-to-sales, enterprise-value-to-sales and enterprise-value-to-earnings, among a whole bunch of others.

According to Montaka Global Investments senior research analyst Amit Nath, valuation multiples are "probably the most enduring pieces of investment analysis of all time".

"'That company is expensive because its valuation multiple is high' — this is one of the most used and repeated phrases of market commentary," he wrote on a Montaka blog.

"Unfortunately, they are often completely useless."

If you only have a hammer, everything has to be a nail

Nath speculated that for many investors, valuation multiples are the only metric they have to judge a stock.

"The law of the instrument, or 'Maslow's hammer', is a cognitive bias where people rely too much on a familiar tool," he said.

"For many market commentators and armchair enthusiasts, valuation multiples are their Maslow's hammer, and they apply it indiscriminately."

According to Nath, valuation multiples are a "simplified, abbreviated and short-cut" way of analysing a business' worth.

"They don't tell the whole story or give a complete picture of underlying value and are prone to sizable error when applied in isolation," he said.

"And, sadly, multiples have never been less useful than they are today."

Abraham Maslow, the psychologist behind the eponymous hammer, explained it the best.

"It is tempting, if the only tool you have is a hammer, to treat everything as if it were a nail."

The trouble is that the world is full of high-growth ventures that are revolutionising their industries or even creating new ones.

"For traditional valuation multiples to be effective, a company needs stable and predictable cash-flows, which are generally found in mature industries like utilities, real-estate and infrastructure," said Nath.

"Multiples provide an inadequate view when companies have high and relatively sustained growth rates, particularly for the world's best software-driven ecosystems like Microsoft Corporation (NASDAQ: MSFT), Alphabet Inc (NASDAQ: GOOGL), Amazon Inc (NASDAQ: AMZN)."

Humans are terrible at exponential thinking

Nath explained that humans naturally prefer to use "a simplifying linear concept", and this simply doesn't represent non-linear phenomena like high-growth businesses.

"Google's world-renowned futurist and Director of Engineering, Raymond Kurzweil, believes humans are linear thinkers by nature, whereas technology, biology and our environment are often exponential," he said. 

"That, he says, creates enormous blind spots when we pursue higher-order thinking and seek to solve increasingly complex problems."

Kurzweil cited a simple thought experiment to demonstrate.

"It takes 7 doublings to go from 0.01% to 1%, and then 7 more doublings to go from 1% to 100%," said Nath.

"So within 14 time periods an emerging system has gone from being completely invisible in the linear world (0.01%), to entirely encompassing it (100%)."

The COVID-19 pandemic recently demonstrated in real life the power of exponential growth, but our brains simply can't handle the concept.

So what do we use instead of valuation multiples?

If valuation multiples are so flawed, what measure should investors use to judge whether a stock is expensive or a bargain?

"The truth is, there are no short-cuts in valuing a business," said Nath.

"It is a hard, detailed, and rigorous exercise that takes considerable time and insight to get right."

He revealed that Montaka conducts considerable research on the industry landscape and how the business might fare in 5 to 10 years.

It also puts together metrics like discounted cash flow (DCF) and total addressable market (TAM) for a full picture of the stock's potential.

Nath put up Amazon to demonstrate how useless it is to base one's stock-buying decisions purely on valuation multiples.

In 2006, Amazon shares were trading at an enterprise-value-to-EBITDA ratio of 26 times, while the US market generally was at 10.

Since then, the stock price has returned 115 times over.

"You could have paid double the share price for Amazon in 2006 and still made nearly 60 times your money today."

John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. Motley Fool contributor Tony Yoo owns shares of Alphabet (A shares), Amazon, and Microsoft. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns shares of and has recommended Alphabet (A shares), Alphabet (C shares), Amazon, and Microsoft. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has recommended the following options: long January 2022 $1,920 calls on Amazon and short January 2022 $1,940 calls on Amazon. The Motley Fool Australia has recommended Alphabet (A shares), Alphabet (C shares), and Amazon. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

More on Investing Strategies

A man wearing glasses and a white t-shirt pumps his fists in the air looking excited and happy about the rising OBX share price
Small Cap Shares

2 small cap ASX stocks with big price targets

Brokers have put big price targets on these small caps this month.

Read more »

Man holding out $50 and $100 notes in his hands, symbolising ex dividend.
Dividend Investing

These ASX dividend stocks offer 4% to 8% yields

Analysts are tipping these stocks as buys for income investors.

Read more »

A happy woman at her laptop punches the air, indicating a rising share price
Dividend Investing

Buy BHP and these ASX dividend shares now

Analysts think that income investors should be buying these shares.

Read more »

Man smiling at a laptop because of a rising share price.
Dividend Investing

Why now presents an 'attractive opportunity' to buy this quality ASX 200 dividend stock

The ASX 200 dividend stock could be trading at a long-term bargain.

Read more »

Man holding out $50 and $100 notes in his hands, symbolising ex dividend.
Dividend Investing

Overinvested in ANZ shares? Here are two alternative ASX passive income options

These investments could add pleasing dividend diversification.

Read more »

Small girl giving a fist bump with a piggy bank in front of her.
ETFs

Here's why small-cap ASX ETFs are on the rise

Some are outperforming the exchange-traded funds tracking the ASX 200 and ASX 300.

Read more »

three businessmen high five each other outside an office building with graphic images of graphs and metrics superimposed on the shot.
Blue Chip Shares

Buy these 3 high-quality ASX 200 blue chip shares in December

Analysts think these high-quality shares are buys right now. Let's see what they are saying.

Read more »

Two smiling work colleagues discuss an investment or business plan at their office.
Dividend Investing

Analysts say these ASX dividend shares are top buys

Here's what sort of yields they are expecting from these shares.

Read more »