The 5-Year Forward Price-to-Earnings Multiple

I tweeted something back in February that I thought was interesting and good for a laugh:

“In hindsight, we can now see that Facebook (FB) was trading at 3x 2017 earnings in late 2012. General Electric (GE), on the other hand, was trading at 20x 2017 earnings...”

This was one of the first responses: “Is price to earnings five years from now ratio a thing?”

As far as I know it’s not a commonly used metric. But that response got me thinking.

The point I was trying to make was that if you could very roughly estimate Facebook’s five-year forward earnings back in 2012, the valuation looked ridiculously cheap. Of course, foreseeing those future earnings – even within a wide range – would’ve been very difficult to do. With that stated (so I can avoid being called out for clear hindsight bias), the broader point stands: In that instance, focusing solely on the current price-earnings ratio really missed the boat. The fact that Facebook was trading at some astronomical price-to-earnings multiple on 2012 earnings didn’t matter.

Let’s try to apply that thought process to some current examples. Here are my rough estimates of normalized earnings per share five years into the future (2022) for some companies I follow:

Using recent stock prices, here are the five-year forward price-to-earnings multiples:

The metric I’ve chosen to use, normalized earnings per share, is worth discussing. The key variable in that metric is run rate margins – what I expect the company to deliver after transitioning through a period of short-term noise. That noise can show up in a number of ways. For example, I think Under Armour (UA)(UAA) has normalized margins that are well above what they reported in 2017; once the company digests some of the investments they made in anticipation of higher near-term revenues, we will likely see the margin profile revert closer to what we saw over much of the past decade.

We see a very different example with Amazon (AMZN). Anybody who does a segment-level analysis of the company's key businesses will see that the current margin profile doesn’t make a ton of sense. My conclusion is that the underlying level of profitability in these businesses is being masked by significant investments. When I estimate normalized profitability, I assume these investments taper off over the forecast period so that the income statement reflects the underlying ("true") economics.

If you accept my assumptions, how should we think about the output? For example, how does Disney with a forward P/E of 10x compare to Amazon with a forward price-earnings of 21x? This commentary from Bill Nygren (Trades, Portfolio) of the Oakmark Funds is worth considering:

“For almost all businesses, our crystal ball goes dark after seven years, so we assume all businesses trade at similar P/E’s after seven years. With an estimate of fair value seven years in the future, we can discount that back at an appropriate risk-adjusted discount rate to estimate today's value. Whether that results in a near infinite or a negative P/E on current earnings is not of concern to us.”

On its face, I have a hard time fully committing to that conclusion. To use an extreme example, isn’t it clear that Amazon (AMZN) deserves a meaningfully higher terminal P/E (or FCF) multiple relative to a struggling brick-and-mortar retailer like Bed Bath & Beyond (BBBY)? While the size of that premium is up for debate, I think most investors would agree that these companies should not be viewed on a level playing field.

But that assumes we have some ability to foresee what the future will look like beyond our forecast horizon – and as we all know from experience, it’s already hard enough to use our crystal ball over the shorter (five- to seven-year) window. Things change (look at consumer staples for a current example). I’m on the fence on this one, but I can see the merit of the approach Nygren has adopted. When I build models, I rarely stray from a level near the historic market multiple, especially when I’m applying that against an estimate of normalized profits.

Coming back to the 2022 P/E multiples, we can see that the output doesn’t have any major outliers (nothing like Facebook at 3x). Disney looks pretty attractive, at least on a relative basis. On the other end of the spectrum, Amazon appears expensive.

A low-single digit 5-year forward P/E will be quite rare. It requires a significant miscalculation by Mr. Market. One example that comes to mind is Visa (V). For a long time, the market did not properly account for the huge operating leverage inherent in the business model. The incremental profitability was off the charts. After Visa was let loose from the banks (and was run by managers who were incentivized to maximize profitability), the true value of the business became apparent.

This is similar to the Facebook example. The big prize wasn’t in finding the “right” P/E. It was in foreseeing the massive runway for growth and profits. For Facebook, this came in the form of hundreds of millions of additional users and huge gains in average revenue per user (ARPU), as well as significant operating leverage as revenues exploded.

That’s where the real value lies. Instead of worrying about the next 12 months, our focus should be years into the future (or as it relates to security analysis, the inputs that drive long-term cash flows). Here are the questions that are most relevant: What needs to happen to reach those five year estimates? Can we get any sense for whether the surprises along the way are more likely to be on the upside or the downside? And what are the variables that could lead the financial results to materially differ from our expectations?

Most of the time you won’t draw conclusions that materially differ from the consensus. Examples like Facebook and Visa are rare. But every once in a while, you may stumble across an opportunity within your circle of competence that others have overlooked for one reason or another (Mr. Market’s shortsightedness seems like a probable cause). In those situations, you may have an opportunity to buy the business at an absurdly low five-year “forward” price-earnings.

If you find yourself in that situation, be sure to take Charlie Munger (Trades, Portfolio)’s advice:

“You won’t get an unlimited number of good ideas – so when they come along, seize them.”

Disclosure: Long MSFT, MCO, UA, CMG and GE