Multiple Compression

Posted on September 18, 2006 by David Laidlaw 

We often use ratios to evaluate the holdings within the portfolios that we manage. The most common ratio is the price to earnings ratio which compares a stock’s price to its earnings per share (total earnings divided by shares outstanding). This ratio allows us (and all investors) to answer the question: how much are we paying for this stock compared to the amount of money that the company is earning. There are many other ratios that are useful. Price/Sales is a simple ratio again comparing the price of the stock to the amount of sales generated per share. This metric can be more meaningful since it is harder for companies to manipulate sales compared to earnings which require many accounting estimates. Another multiple that is useful is price to cash flow which again looks at the price of the stock, but compares that price to amount of cash flow that is generated. This measurement is useful for evaluating businesses that have high non-cash expenses such as depreciation. Multiple comparisons are especially useful in comparing businesses in the same industry at a specific point in time.

Multiple comparisions are also helpful when comparing markets and specific companies through time. During certain periods the market is willing to pay more or less for given levels of earnings or sales. Generally, these multiples vary within a fairly narrow band, but these ratios often get extreme. During the frenzied technology driven bubble, the market was willing to pay very high prices for very little compared to sales, earnings and cash flow. On the other hand, during the late 1970s, the market was willing to pay very little for high levels of earnings and sales due to inflation and pessimism regarding future growth. Over the last couple of years, we have seen multiples compress. Coming out of the mild recession and starting in 2003, the market paid high mutliples on earnings with the expectation that earnings and cash flows would increase (which they did). The situation is now reversed. Sales and earnings have increased significantly, but the market is willing to pay less and less for those sales and earnings. This phenomon is referred to as multiple compression.

This phenomenon is especially true for the companies in the portfolios that we manage since we tend to buy profitable companies at reasonable prices. Earnings within these companies are expanding nicely, but the stock price is not moving as much. A number of our core holdings are trading at historically low multiples. For example, four years agoMedtronic earned about $0.80 per share during its fiscal year that ended in April of 2002. At this time, the stock sold for roughly $44 per share. From August 2005 until its most recent report at the end of July 2006, Medtronic earned $2.36 per share. However, Medtronic’s stock sold for $46.10 at the end of September this year. The stock price appreciated a grand total of 5% excluding dividends even though its earnings nearly tripled during the period. Over this span, Medtronic’s P/E ratio decreased from a lofty 55X to a reasonable 19.5X.

When mutliple compression occurs, we do not reposition our portfolios to catch those stocks or sectors that we believe will move in the short-term. Instead, we monitor the underlying fundamentals and hold those companies that are executing their business plans well with the expectation that the value for our holdings will eventually be realized by the broader market.