Strategy: What's in a multiple after all? - Kotak

What's in a multiple after all? We wonder if the Street is paying sufficient attention to underlying assumptions (volumes, profitability, market shares, market structures, among others) while assigning higher 'target' multiples (P/E or EV/EBITDA) to 'justify' the rapid inflation in stock prices. Our hypothetical exercise to measure the required 'output' volumes related to changes to 'input' multiples reveals rather eye-popping outcomes for the underlying volume assumptions in the longer term.

Hypothetical exercise trying to link 'output' volumes with 'input' multiples

The hypothetical DCF model of a company. We have built the assumptions for profitability, realization and volumes and related capex such that the 'stock' trades at 24X 1-year forward P/E and 14X 1-year forward EV/EBITDA. We would clarify that the absolute figures regarding the underlying profitability, realization, volumes and capex are not relevant for the purpose of this exercise. They are for illustrative purposes only.

It is easy to increase multiples on paper with modest increase in price, volume assumptions

The combination of growth in price and volumes that is required to support higher multiples. We keep the other assumptions related to profitability and WACC unchanged. In our base-case scenario, we use 5% volume growth and 4% realization growth to arrive at a one-year forward P/E of 24X. As can be seen, the same 'stock' would require 10% volume growth and 6% realization growth or some such combination for it to trade at 44X.

It is harder to appreciate the implications for underlying assumptions in the longer term

The Street's penchant to increase 'target' multiples with a few keystrokes on short-term events perhaps misses the longer-term implications for the underlying prices and volumes of such casual changes. We note that the impact of any change in underlying price and volume growth assumptions will get exaggerated in the long term. In our hypothetical exercise, the 10% volume and 6% realization growth scenario (see Exhibit 3) will entail 614 units of volume and 292 units of price in the terminal year (20 years later) versus 241 units of volume and 199 units of price in the 24X base-case scenario. In other words, volume output would need to be around 2.5X and price about 50% higher versus the base-case multiple scenario of 24X for the new 44X multiple to be 'valid'.

It may be useful to check the underlying assumptions

It may be useful to check the underlying assumptions (price, volume, profitability, market share, market structure, among others) to understand the 'validity' of multiples. Multiples can change quite easily (with a few keystrokes or changes in consensus view, usually shaped by stock prices) but underlying market economics and structures may not change that easily. Investors may want to check if the market (as in for the company's products or services) will support the underlying assumptions being implied by its valuations. As our reverse valuation exercises for various sectors and stocks show (see our May 25, 2017 report What lies beneath?), the underlying volume assumptions are quite unrealistic in several cases. Exhibit 4 shows the hypothetical output of price and volume growth combinations over 10 and 20 years. This is a simple CAGR table but it is highly underappreciated, in our view.

Source : Equity Bulls

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