Equity Valuation and Portfolio Management

KEY POINTS

• A “fundamental no-growth firm” with no prospects for productive investments will have the same intrinsic “tangible value” (TV) today, whether it pays out all its earnings or reinvests part or all of them at the market rate. The no-growth firm's “base” P/E will be the reciprocal of the market capitalization rate, k, for equities. A “growth firm” with significant “franchise value” (FV) must make future investments that provide a positive “franchise spread” (a return that exceeds the market-based cost of financing). For reasonable franchise spreads, high levels of future franchise investments (measured in today's dollars) are required to significantly raise the FV. Typically, the required magnitude of the future investments may be as much as two or more times the firm's current book value.
• The “natural orbit” of the P/E ratio is a decaying one. As anticipated investments are made and new businesses develop and grow, the firm's franchise value is “consumed” and converted into TV. Absent surprise opportunities, the balance between TV and FV shifts toward TV and the P/E inevitably declines. It is as if there is a natural gravitational pull toward the base P/E ratio.
• Hyper-franchise firms may experience bouts of “supercharged” growth from capitalizing on outsized returns on equity, especially in their early years. This growth is theoretically limited in scope and duration even though there are many examples where supercharged growth persists for 5, 10, or more years.
• The shorter-term, ...