Quality Deserves a Higher Multiple. But How Much Higher?

Is 10 times earnings cheap? Is 25 times earnings expensive?

Those questions sound simple, but they are incomplete. A valuation multiple is only a price tag placed on a stream of future earnings and cash flows. Before deciding whether that price tag is attractive, we first need to understand what sits behind it.

This is why I am uncomfortable with valuation rules built around absolute P/E cutoffs. A company can be expensive at 10 times earnings and attractive at 25 times. The difference is not the number itself. It is the quality, durability and reinvestment economics of the business we are buying.

The Same Multiple Can Mean Very Different Things

Consider two companies that both trade at 15 times earnings. On a stock screener they may look equally valued. In reality, they can be very different investments.

Figure 1. Same multiple, very different economics

Before deciding that either company is cheap or expensive, we need to understand the earnings behind the multiple. Are they normalized or temporarily elevated? How much turns into free cash flow? How durable are the margins? How much capital is required simply to maintain the current business? And can retained earnings be reinvested at attractive rates?

A low P/E ratio does not automatically provide a margin of safety. Sometimes it reflects a weak, cyclical or declining business. In the same way, a higher multiple does not automatically mean that a company is overvalued. A business capable of compounding earnings for many years may deserve a materially higher valuation.

Quality Deserves a Higher Multiple

One of the characteristics I look for is a high return on invested capital. But high ROIC by itself is not enough. The most valuable combination is a business that earns high returns on capital and still has room to reinvest additional capital at attractive rates.

That is where compounding becomes powerful. If a company can retain part of its earnings and repeatedly reinvest them at high incremental returns, the earnings base can grow for many years without requiring large amounts of new external capital.

Compare that with a company that earns a low return on capital and must reinvest most of its cash flow simply to maintain its competitive position. The accounting earnings may look similar today, but the economic value of those earnings is very different.

The reason is simple: growth has a cost. A company that wants to grow has to invest capital, but the amount it must reinvest depends on the return it earns on that capital. The illustration below holds current earnings and the growth rate constant and changes only ROIC. That isolates what quality can mean economically.

Figure 2. Same earnings and the same growth rate, but very different reinvestment needs and valuations

Source: REQ Capital.

Each of the four businesses earns 100 and grows at 5%. The low-ROIC business, earning 6% on capital, must reinvest 83 of its 100 in earnings to finance that growth. Only 17 is left for owners. The excellent business earns 40% on capital and needs to reinvest just 13 to support the same growth, leaving 88 for owners.

Under the illustration's simplified 8% cost of capital assumption, that difference produces a value of 555 for the low-ROIC business and 2,917 for the high-ROIC business. The corresponding forward P/E moves from 5.6x to 29.2x, even though current earnings and the growth rate are identical.

Another way to think about these multiples is through the return required by the investor. In this simplified example, an investor targeting an 8% return could pay around 5.6 times forward earnings for the low-ROIC business, but as much as 29.2 times for the high-ROIC business and still expect the same 8% return, assuming the underlying assumptions are realized.

This is why the value of growth depends on how much capital is required to create it. Growth that consumes most of today's earnings is much less valuable than growth that can be funded with a small part of them. A higher multiple can therefore be perfectly rational when the underlying business converts each euro of capital into much more economic value.

But Quality Does Not Make Price Irrelevant

There is an important qualification. A great business is not worth any price.

It is easy to take the quality argument too far and conclude that valuation no longer matters. It does. Even an exceptional company can deliver disappointing shareholder returns if the starting price already assumes decades of near-perfect execution.

A very high starting multiple creates an additional source of risk. Earnings may grow, but the multiple can contract. In that situation, the business can perform well while the investment performs poorly.

This is why I do not think investors should choose between quality and valuation. The objective is to combine them: find good businesses, understand why they are good, estimate how long their advantages and reinvestment opportunities can persist, and then pay a sensible price.

The Multiple Is an Output

A multiple compresses many assumptions into one number: expected growth, capital intensity, competitive durability, balance-sheet risk and the length of the reinvestment runway. Applying the same valuation rule to every company gives an appearance of discipline, but can remove the part of valuation that matters most.

For me, the relevant question is not whether a multiple looks high or low compared with the market or with history. It is whether the price allows for an attractive return under assumptions that are sensible rather than heroic.

That is a harder question than asking whether 10 times earnings is cheap.

But it is also the question that matters.