Valuation
Sound of alarm bells
The April 27, 2024 article at page 61 of The Economist magazine started with the sound of alarm bells. The author declared: “Shares have rarely been valued more highly than they are today, giving them further to fall and making them more vulnerable to changing investor sentiment.”
Dramatically, we are told that the cyclically adjusted price-earnings ratio (CAPE) is now higher than it was even in the late 1920s!!
In this post I am going to write about multiples. We will draw a few insights from a recent report dated April 23, 2024 published by Morgan Stanley titled Valuation Multiples – What They Miss, Why They Differ, and the Link to Fundamentals written by Michael J. Mauboussin and Dan Callahan.
We will also take a look at some numbers from the financial statements of VEEVA SYSTEMS INC which are a good example of how the world has changed in the last fifty years.
Creation of intangible assets
Let’s start with a quote from Mauboussin and Callahan. “In prior generations, businesses invested primarily in tangible assets such as factories and machines. These investments were recorded on the balance sheet and expensed on the income statement through depreciation. Today, the majority of investments are in intangible assets, including customer acquisition costs and branding.”
“But companies commonly expense these investments on the income statement as they incur them. Accountants record these investments as selling, general, and administrative (SG&A) and research and development (R&D) expenses. This reduces current earnings.” (Emphasis added)
These investments in intangibles often create very substantial intangible assets of lasting value. These intangible assets, in turn, spin cash from operations. But, for the most part, these very substantial intangible assets do not appear on the balance sheet.
Back to multiples
The Economist article compared CAPE today with CAPE in the 1920s. That would be fine if the world had not changed since the 1920s. Some things change and other things stay the same.
When we look at a bunch of historic data, what statisticians call a time series, we always have to be on the lookout for the world having changed. In statistician-speak it’s call non-stationarity of data. As Mauboussin and Callahan tell us, in prior generations, in the old days, most company investment was in tangible assets like buildings and equipment. Today, its all about investment in intangibles. And this has a significant impact on reported earning and on balance sheets.
The E in CAPE is earnings. The time series of data on corporate earnings exhibits serious non-stationarity. The E in Price Earnings Ratios (P/E) and the C in Return on Invested Capital (ROIC) are both victims of non-stationarity of the time series of data. If you read the Mauboussin and Callahan report, remember ROIC is also distorted.
Their conclusion is bang on: “…the main point is that multiples are getting worse at reflecting the economic picture they are supposed to capture. A blind deference to multiples without understanding their limitations can severely hamper the effectiveness of an investment process.”
VEEVA SYSTEMS INC
Veeva Systems Inc. VEEV NYSE/US is a provider of cloud solutions for the global life sciences industry. It currently has a market cap of $32.8 billion. In the fiscal year ended January 31, 2024 it invested $26.2 million in tangible assets. It spent (invested) $ 629.0 million in Research and development. In other words, what it spent with potential to generate intangible assets of lasting value completely overshadowed what it spent on investment in tangible assets. On top of that, it may also have generated intangible assets from its spend on General and administrative expenses. It generated $488 million in net income. That’s what it has to pay tax on. But it generated $780 million in free cash flow. That’s cash left over after all expenses and investments. It sits with Short-term investments of $3,324 million on its balance sheet. That’s in addition to cash in the till of $703.5 million as against $32 million of accounts payable. In other words, its a cash machine.
The balance sheet shows $4,644 million of shareholders’ equity which includes roughly $500 million of reported intangible assets. Here’s the kicker. The market values the equity at $32.8 billion. The market suggests the company has over $30 billion of intangible assets not shown on the balance sheet.
P/E as a multiple and ROIC as a multiple do not reflect the economic picture they are thought to capture.
Conclusion
Intangible assets are just that, intangible. You can’t kick them, but they seem to have value. They seem to produce cash. I make no comment on whether or not the market is overpriced or cheap. My only point is that the simplistic use of multiples is not a reliable indicator.
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I have written a number of other posts touching this subject. You might check them out.
The emergence of a new model of capitalism
Is the price earnings ratio (P/E) obsolete?
The fading usefulness of book value
Profound errors in interpreting and using ROE and ROC
Stock valuation in an age of intangible assets
How to identify companies that make lots of money for shareholders
What is the right price earnings ratio?
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For readers wanting to dig deeper into this subject, take a look at Chapter 39. Use of ratios to value shares
In particular, Chapter 39 contains the following relevant Sections:
39.02 Perspective from the 1990s
39.03 Perspective from the 1980s
39.04 Perspective from the 1950s, 1960s and 1970s
39.05 No simple explanation for ups and downs
39.07 A cycle for inflation and interest rates
39.08 Inflation and price earnings ratios
39.09 Price earnings ratios and interest rates
39.10 Impact of changes in interest rates
39.12 Price earnings ratios through the cycle
39.13 Earnings and investment in intangibles
39.14 Price to free cash flow ratio
39.15 The impact of write-offs on subsequent year comparable earnings
39.17 Is there a correct price earnings ratio for any stock at any particular time?
39.18 The joy of multiple expansion
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You can reach me by email at rodney@investingmotherlode.com
I’m also on Twitter @rodneylksmith
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Check out the Tags Index on the right side of the Home page that goes from ‘accounting goodwill’ to ‘wisdom of crowds’. This will give readers access to a host of useful topics.
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You can also use the word search feature on the right-hand side of this page to find references in both blog posts and also in the Motherlode.
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There is also a Table of Contents for the whole Motherlode when you click on the Motherlode tab.
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