Tuesday, July 24, 2007

The New PE Ratio Revisited


Back on June 5th, I posted the following comment: "It can be heard with increasing frequency that your standard P/E (price to earnings) ratio should be replaced with a new PE (private equity) ratio. As the chart to your left shows (see June 5th posting), the combination of stock buybacks and PE deals is reducing the supply of equities and, thereby, adding fuel to the bull market fire. At around $2 trillion and counting, corporate cash and PE deal money (not to mention the $1.5 trillion in cash plus the 4 to 8 times leverage from the hedgies) are clearly having a profound impact on many areas of the investment landscape.


Equity valuation 101 teaches us that private market values are always higher than public market values. Accordingly, investor expectations can be reset to a higher level if enough investors believe more deals are on the way. A price to deal ratio, if you will. As with all new era talk, however, it is advisable to temper the enthusiasm as expectations based upon a continuation of the extraordinary stock buyback + PE driven deals at the current pace may not be sustainable resulting in PEs reverting back to P/Es."

Since that posting, a whole raft of issues have arisen in the private equity space the result of which is an increasing concern that the equity markets in the US may be losing a main engine of stock market appreciation - the private equity machine.

Investment Strategy Implications

Stocks are rising in emerging markets and for the companies that serve those markets due to the extraordinary growth rates there and the assumption that there is more to come. In the US, however, a great deal (some say too much) of the equity price appreciation is due to the power of financial innovation, with private equity and hedge funds at the forefront. Should the PEs and hedgies' difficulties not only persist but expand, stocks will likely slip back to their pre PE valuation days. Moreover, should the earnings outlook change, then a much more substantial decline in stocks would occur in which both the multiples would contract (from PE to P/E) and as the E itself drops. This scenario is most definitely not what the current market level is priced for.

1 comment:

Mike said...

Vinny…I don’t understand this comment.

"Equity valuation 101 teaches us that private market values are always higher than public market values.”

My experience had been that private companies (if that’s what we’re talking about when we say market values) are generally valued lower than public companies…hence the step up in values that we see as soon as a company begins trading. Did I miss something or take something out of context?

Mike

Mike,

It has always been my understanding that the control factor (the ability to control the assets of the company without regard for minority shareholder interests) is the primary reason why private market values are higher than public values when considering an existing publicly-traded company. Hence the takeover premium. In other words, the minority interest inherent in a publicly-traded company trades at a discount to the majority control interest that occurs when taking a public company private.

Where private values are below publicly traded companies is when the company is private and plans to remain so. Then a discount for the lack of liquidity of ownership comes into play.

Make sense?

Vinny

Vinny…that’s an interesting position to consider and perhaps it assumes total effective ownership (even that which is in minority hands). This will of course come as no surprise that most knowledgeable investors would rather be minority shareholders in a public company that ones in a private company, therefore bidding up the values of fractional ownership in public entities.

It also causes me to ask the question…why then do most companies believe they have to go public to get full market value…and the answer is: because the number of private buyers may be limited and theoretically the public ones are not.

Thoughts?

Mike




Mike,

A few thoughts:

1 - The revolving door from public to private and back is the private equity game with the assumption that the public entity is undervalued and to some degree mismanaged thereby presenting the opportunity to capture a bargain at takeover prices.

2 - It is my understanding that most private companies do not go public to realize a full market value but rather to gain access to more capital. Moreover, in the private equity revolving door scenario, once all the potential operating improvements have been realized thereby producing a much more efficient company, the assumption is that the public market would embrace it with a higher value than a comparable, existing but less well managed publicly-traded company.

3 - In both public and private companies, minority interests are always less valuable than a control interest. Control does not have to equate to majority interest, although it usually does.

4 - Most investors are mandated to invest only or primarily in public issues as private companies present a whole set of skills for analysis that makes it much more difficult to do.

5 - With the emergent power of private equity and hedge funds, massive liquidity, and advanced asset management skills, many professional investors are comfortable with allocating x% to private ventures, usually viewed as a separate asset class (alternative investments).

Now, your thoughts?

Vinny

Vinny…my final thoughts would be to quote my old granddad…”Buy low, sell high, collect early and pay late.” It’s all about cash flow!

Mike

Granddad gave excellent advice.

Many thanks for the dialogue.

Vinny