I recall being taught about this new valuation methodology called EV/Sales or EV/Revenue when I was new in the industry. It was the new paradigm and I was told it was the new way to value companies. I was running a small LIC at the time and was investing in things that looked incredibly cheap on a cash flow or after tax basis. It was about 1999 or 2000, I don’t recall the exact year but I do recall wanting to keep that report from a very big investment bank as I knew it was rubbish.
We are back there again. I was watching a Livewire video last week and heard a small cap fund manager talking about how a stock is cheap on an EV/Revenue basis.
ARE YOU CRAZY???
Then I see this chart…
And now I know we are back there. This is the start of a long value bull market. The same as we had from about late 2002 until 2007. Incredibly cheap real businesses, with real cash flows, decent balance sheets and good management. They are just not sexy. These businesses are the ones that have been de-rated as the mob buys BNPL stocks.
Now it may not start straight away but one thing that will happen is that ETF’s and Index funds are dumb buyers of stocks and momentum creates momentum. So the bigger a stock becomes in the index the more index funds and benchmark hugging funds have to buy of it. There will be a catalyst for these momentum EV/Revenue stocks to one day get valued on EV/EBITDA like the rest of the market and there will be some pretty sharp falls. Just as we saw when Afterpay went down 80% from $40 down to $8. It can and will happen to some of them and the selling will create more selling.
Investors will then shift their attention to owning good quality industrial businesses with attractive valuations, these companies will get re-rated slowly from single digit PE’s to double digit PE’s.
If you buy a business on a PE of 7 times, without over complicating for things like debt and interest you are going to own that business in 7 years from the cashflows of the business or it should be twice as big if it reinvests all its profits. I know that’s over simplifying things but the concept is very simple. If you take a medium-term view and buy these companies with a 5 year time horizon you will do very well in a lower risk profile than buying a company on an EV to revenue of 20x. You can’t feed yourself from EV/Revenue, you can pay the bills from dividends.
The justification for some of these valuations being so high is that discount rates have reduced because interest rates are lower. If you have ever lent money to companies you will know that for many companies the interest rates rarely vary and we have also just had a range of events that for many small businesses will worsen their credit rating and actually result in an increase in interest rates or at the worst the margin they are paying over a reference rate. Do you see your credit card interest rate reduce ever? Small business loans are similar.
It also doesn’t explain why there has been a massive divergence between growth and value companies, momentum and value companies and a gross underperformance of companies based on size, should they all go up because the discount rate has fallen? Or are small value companies just about to have their time in the sun because the discount rate is lower and people just haven’t realised that yet?