Brian Michael Nelson, CFA, is the author of Value Trap: Universal Valuation Theory.
“People’s thought process is too bound by conventions or analogies with previous experiences. It’s rare that people try to think of something from first principles. They say, “We’ll do it because it’s always been done that way.” Or they won’t because, “Well, no one has ever done it, so it must not be good.” But that’s just a ridiculous way of thinking. You have to build reasoning from the ground up – “from first principles” is the phrase used in physics. You look at the fundamentals and build your reasoning from that, and then see if you have a conclusion that works or not, and may or may not be different than what people have done in the past.” – Elon Musk
I couldn’t sleep. I knew something was wrong. The numbers just didn’t make sense. For years, pipeline energy analysts seemed to be adjusting their valuation models for master pipeline limited partnership (MLP) stocks in order to explain what was going on with the price.
But why? Why adjust the models for one set of companies and not another? Cash is cash and value is the measure of cash flowing in and out of a business. There are no different rules for different companies. The assessment is universal.
Analysts valued MLPs based on the price-to-distributable cash flow valuation multiple and the distribution yield, or the distribution per share divided by the share price. But growth capital spending supports distributable cash flow and pushes it further into the future. The pipeline’s MLP valuation calculations ignored this. Why should pipeline MLPs receive a free rollover of equity capital invested in growth projects when other companies did not?
How unbalanced were the MLP valuation processes? Meta Platforms, formerly Facebook, will spend at least $10 billion this year on its metaverse division, Facebook Reality Labs, to build virtual and augmented reality applications. Imagine ignoring those billions in growth capital spending and still giving Meta credit for the free cash flow growth associated with that spending. That’s what happened to MLPs and distributable cash flow, and when the market got stuck, pipeline MLP stocks collapsed.
I describe the history of Kinder Morgan and MLP in my book Value trap because it emphasizes first principles. The discounted cash flow (DCF) model is universal. So what do I mean by that? And what are the first principles? Let’s take P/E ratios. Although each valuation multiple can be expanded into a DCF model, P/E ratios are not necessarily shortcuts to the DCF model. When misapplied, they can lead to the wrong conclusions about a company’s value.
For example, a P/E ratio of 15 may be cheap for one company and expensive for another. This is because certain variables have a confounding effect that limits what valuation multiples can reveal about a stock’s value. The cheap company might have billions in net cash on the books and great growth prospects, while the expensive one might have billions in debt and poor growth prospects. However, they still have the same P/E ratio.
Valuation multiples can be useful when applied correctly and with an understanding of what they are proxies for. That low P/E may not be cheap if the company has a huge net debt position. That high P/E may not be expensive if it’s asset-light with a cash-rich balance sheet and strong free cash flow growth prospects. But many analysts have forgotten that P/E ratios are an imperfect substitute for the DCF model and should not be used in isolation.
This has opened the door to all kinds of spurious financial analysis. Think of all the factors that statistically “explain” returns based on this or that multiple. There are thousands of forward-looking assumptions built into each valuation multiple. Just because that multiple is high or low doesn’t mean the stock is a good buy.
Many analysts today apply P/E, P/B, EV/EBITDA and other multiples by themselves as if they were separate from the underlying DCF model that they are derivative from. Some even question whether the DCF model is still relevant. Does forecasting future free cash flows and discounting them to the present at an appropriate rate still make sense in the age of GameStop and AMC Entertainment meme stocks?
The answer is yes. In valuation, first principles remain essential: every valuation multiple has an implicit DCF model behind it.
With MLPs, we know what was going on with their valuations. Relying on “distributable” metrics is like valuing Meta deducting only an estimate of its “sustainable” capex, completely ignoring its growth capex related to the metaverse, and still crediting the company with future cash flows cash generated by this expense.
The MLP bubble demonstrates how applying valuation multiples without a supporting DCF model can be a recipe for disaster. In fact, using valuation multiples without a solid foundation in first investing principles won’t yield much information. Only the DCF model can help determine which 15 P/E stocks are cheap and which are not.
These errors may help explain the replication crisis in empirical quantitative finance. I believe that most statistical analyzes that explain stock market returns using valuation multiples are flawed. The relationship between stocks with similar multiples has not really held up in recent years. Why did we ever think it would or could?
If we can understand that two stocks with the same P/E ratio can be undervalued or overvalued, why do we think that the performance of stocks with similar valuation multiples would yield actionable data? And what does this imply about the conversation between value and growth? If we didn’t use the DCF model, we could all be taking a random walk when it comes to value and growth.
All of this helps explain why the DCF model is not only relevant to today’s market but remains an absolute necessity. As the 10-year Treasury yield rises and stocks come under pressure, we need to consider the DCF model. After all, these returns form the basis of the weighted average cost of capital hypothesis.
In this changing landscape, a return to investment first principles is inevitable, and the DCF model is an essential tool for navigating what lies ahead.
For more information from Brian Michael Nelson, CFA, don’t miss it Value Trap: Universal Valuation Theory.
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All posts are the opinion of the author. Therefore, they should not be construed as investment advice, nor do the views expressed necessarily reflect the views of the CFA Institute or the author’s employer.
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Brian Michael Nelson, CFA
