The Folly of Valuation Multiples
Posted on June 18, 2010
The other day I had an interesting back and forth with a colleague of mine about the target price for a recent stock recommendation I posted on this site.
While I argued for a higher price target based upon my future cash-flow expectations and a lower discount to the standard industry multiple, he presented a case for lower future cash-flow and a larger discount to the industry multiple.
Who was right? At this point, both of us and neither of us. The argument proves the fact that in the Markets there is no way to prove or better yet disprove (ala Popper’s Falsifiability concept) any valuation proposition, and so all valuation propositions are inherently false and meaningless.
Since the entire art of valuation rests upon future cash-flow expectations and subjective terminal multiples based upon discount rates, the entire process can be characterized as a great folly.
The folly is two-fold:
1. The future is unknowable, especially for outside investors. While a range of cash-flow projections seems reasonable, the probability of each case is open to interpretation and yields vastly different valuation targets. There is no way to prove any case, since you can’t prove or disprove the future.
2. Assigning multiples and applying discount rates is entirely subjective. Small differences can lead enormous pricing differences. Moreover, in an era of 0% interest rates, it is irrational use any sort of discounting for valuation purposes, since there is no risk-free rate to reference. One is justified, in theory, in applying a nearly infinite multiple to any future cash-flow since the risk-free rate is 0. You cannot falisify any discount mechanism.
So what’s the solution?
I’m not quite sure. But I think it’s fair to say that Market prices no longer have anything to do with quantitative valuation, since such a valuation is unprovable and logically unfeasible in the current financial environment.
The situation is in actuality no different than the demise of book value investing, as the economy moved away from factories to services and other businesses that relied mostly on intangible capital.
What’s needed, I guess, is a new valuation framework which relies heavily on qualitative and psychological factors that we agree are inherently meaningless.
Once one accepts the irrational nature of marketing pricing, one ceases to rely on indefensible quantitative methods, and instead one tries to understand the nature of irrationality. In general, the one proposition of irrationality that I think holds, since there is plenty of evidence for it, is that irrational events, such as the Market, tend to always reverse, as I’ve described here.
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