Saturday, January 9, 2010

Bounceback in Multiples: The 2010 story

Building on the 2010 data, here is the other side of the data. As risk premiums have reverted back to pre-crisis levels, we are also seeing multiples also revert back to pre-crisis levels. This can be seen on a number of measures, both in the US and globally:

a. Price Earnings Ratios (PE): The median current PE ratio for US stocks, which plunged from about 19 in January 2008 to about 9 in January 2009, is now back to almost 15. Similar shifts have occurred in the trailing and forward PE ratios and in most sectors.

b. EV/EBITDA: The median EV/EBITDA multiple for US companies, which had dropped from about 9 in January 2008 to 6 in January 2008, had bounced back to 8 by January 2009.

The bounce back in multiples in emerging market companies has been even more robust. The shifts in multiples globally parallel the change in equity risk premiums that I noted in the last post.

The change in multiples in 2010 brings home a fundamental fact that the multiples of earnings, book value or revenues that we are willing to pay depends upon how risk averse we are (and the risk premiums that we consequently demand). That is one reason why I have always been wary of those who compare market multiples across time and pass easy judgments on whether stocks are cheap or expensive.

12 comments:

溫暖 said...

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Immortal said...

vry right professor..agree with u!!!

Gaurav Mehta said...

It'd be great to have an article on the new proposed laws for banks by The President. I personally do think they should be implemented in some for if not the current form.

James said...

Hi Aswath,

Aren't you essentially a "market follower" if you use implied equity risk premiums (or an estimate of current equity risk premiums) in your valuation? Why should you adjust the risk premium you use simply because everyone around you is panicking?

Also, thank you for the incredible resources you have made available on your site.

Aswath Damodaran said...

When you use the implied equity risk premium to value individual companies, you are just separating your market views from your views on a company.

To see why, assume that the implied premium is 4% but that you believe it should be 6%. If you value a company using a 6% premium, you will obtain a much lower value for the company. However, the reason for your finding has little to do with what you think about the company and more to do with your view that the market is over priced.

James said...

I agree, although I'm not sure I've conveyed my original point very well.

Imagine that you use the prevailing implied equity risk premium of 4% to value Coca-Cola, with the resulting valuation indicating a buy decision. Now imagine that panic grips the market because Bernanke is not confirmed for a second term. Suddenly, the implied equity risk premium rises to 6%. If you use this new risk premium to value Coca-Cola, you will get a much lower DCF valuation. If we assume that the resulting valuation indicates a sell decision, and you act on that decision, you have successfully followed the market (and lost money in the process). Obviously it is nonsense to allow stock market fluctuations to inform your view of the value of Coca-Cola, but isn’t that what using an implied equity risk premium does?

Aswath Damodaran said...

True, but your problem in this case was not that you bought Coca Cola but that you allocated a significant portion of your portfolio to equities. If you want to take a point of view on equity risk premiums, it should be in the asset allocation stage. If you believe that the current equity risk premium is too low, allocate less of your money to equities and more to another asset class. Then go out and analyze individual companies to see which ones you would hold with your reduced equity allocation.

Gaurav Mehta said...

Wouldn't it be better to have a 5% risk premium for the growth stage and revert back to the historical 4% in the terminal value? As such there are more chances of equity prices going down this year than going up as central governments takes roll back steps.

Aswath Damodaran said...

That is a good compromise and one that I have used for much of the last year.

Gaurav Mehta said...

Thanks for the clarification, just saw the reply today!

leon said...

In January 2010 you wrote the following in your article "Bounceback in multiples":

b. EV/EBITDA: The median EV/EBITDA multiple for US companies, which had dropped from about 9 in January 2008 to 6 in January 2008, had bounced back to 8 by January 2009.

Could you clarify the dates as this doesn't make sense as is.

Thanks.

Gaurav Mehta said...

The median EV/EBITDA multiple for US companies, which had dropped from about 9 in January 2008 to 6 in January 2009, had bounced back to 8 by January 2010.

This is how it should be read...