Market Distortions | Just An Illusion

Do U.S. Listings Result In A Higher Earnings Multiple?

The table below demonstrates the stark contrast in valuation multiples achieved by U.S. listed companies relative to their European counterparts.

The logical conclusion that one might draw from this is that the same company would be capitalized at a higher multiple of the same earnings if listed in the U.S. compared to Europe. This is clearly what has motivated Cambridge based ARM’s owner, Softbank, to I.P.O. the company in the U.S. rather than on ARM’s home U.K. stock market.

Their belief is that listing in New York will enhance the valuation and the capital raised from the I.P.O.

But this is flawed thinking and even sophisticated institutional investors such as Softbank seem to have missed the point. The market does not determine the valuation of individual companies; rather it is the individual companies that determine the average valuation of the market.

It is all about capital productivity or how the assets of the business are put to work. The higher valuation multiples of U.S. companies is entirely due to the tendency of U.S. companies to generate faster growth by retaining and reinvesting a higher proportion of earnings into the business.

The ability to achieve accelerated growth and to deploy capital in the most productive manner is the key to corporate success because the more return that a business is able to generate on incremental capital, the less capital it needs to grow.

Many European companies, particularly in the UK, feel obliged to pay healthy dividends. The chart below shows the dividend payout ratios by geography. It clearly shows that the UK is the highest while the US is consistently the lowest.

Accordingly, balance sheet capital is distributed to shareholders as a priority. This may be at the opportunity cost of not paying down debt or not reinvesting that money in corporate growth. The fact of the matter is that dividends are a serious impediment to growth (to understand why, click here).

Worse still, some CEOs fail to recognize the insanity of distributing their balance sheet capital as dividends, only to then embark on a capital raise through the debt or equity market in order to finance investment in the business. They either dilute their shareholders, or incur unnecessary financing costs, simply to pay dividends. They then wonder why they under-perform and why the market is ascribing them a low valuation multiple!

Allow me to demonstrate with reference to See’s Candy, a Berkshire Hathaway company. In 1972, Warren Buffett bought See’s Candy for $25 million. At the time it had about $8 million of net tangible assets (including working capital). This level of tangible assets was adequate to conduct the business without the use of debt, and See’s was earning about $2 million after tax at the time. So Buffett paid $17 million over net tangible assets for See’s Candy, meaning that is was capitalized at 12.5x its earnings.

Now let’s imagine a hypothetical rival company called Saw’s Candy, that was also generating $2 million of earnings but on $16 million in net tangible assets. This company has growth prospects that are not as favourable as See’s Candy because to double its earnings it would need to raise $16 million of new capital. See’s Candy would only need an additional $8 million.

Said differently, if both companies raised an additional $16 million in capital, See’s Candy could triple its earnings, while Saw’s Candy would only double its bottom line. Accordingly, given the choice, where would you rather invest your money? The answer is clear. See’s Candy is the better investment opportunity which is why it will trade in the market at a premium to Saw’s Candy. In other words, the market price brings both opportunities back into equilibrium. So Saw’s Candy may only trade at the value of its net tangible assets, $16m - capitalized at 8x earnings.

So the ROIC of See’s Candy was 25% ($2m earnings on $8m capital) which justified a 12.5x P/E ratio, but for Saw’s Candy capital productivity was only 12.5% ($2m earnings on $16m capital) which resulted in an 8x P/E ratio. Both companies have the same earnings, but the earnings multiple is very different.

Hopefully I haven’t lost you. Stick with me as we are almost there. Let’s apply this back in the market at large.

In 2018, the median large-cap U.S. company achieved a 30% ROIC (excluding goodwill and intangibles), while their European counterparts were only achieving 19%. Just like in our example above, the huge divergence in capital productivity leads to a very different P/E ratio as demonstrated. This is born out in fact by the table at the start of this post.

The variance can be attributed in part to the differing industry composition of U.S. and European indices. Notably, the U.S. possesses a more extensive presence of high-ROIC sectors, particularly technology. It is also down to cultural issues. McKinsey’s Corporate Performance and Analytics Tool (CPAT) examined a sample of more than 2,000 U.S. and European companies with revenue of more than $1 billion. Between 2014 and 2019, large European companies were 20 percent less profitable (measured by ROIC), grew revenues 40 percent more slowly, invested 8 percent less (capital expenditure relative to the stock of invested capital), and spent 40 percent less on R&D than their U.S. counterparts.

Hopefully you are now starting to understand why U.S. and European companies trade at entirely different multiples.

It's important to note that these broad comparisons overlook the fact that specific European companies, like sports car manufacturer Ferrari which generates 25% ROIC and trades on a P/E of 48, outshine many of their U.S. counterparts in terms of capital productivity and so they command premium valuations in line with the U.S. high performers. This goes to prove that in the 21st century, investors are not geographically constrained, and so a high-quality company listing in Milan, London or Frankfurt will achieve exactly the same premium valuation multiple as it would with a NASDAQ listing in New York.

In conclusion, as I have hopefully demonstrated, the market in which a company lists its shares does not determine its valuation; instead, individual companies determine the average valuation of the market.

The fact that the U.S. indices achieve a higher average price premium over European indices is simply indicative of the average U.S. business being better than the average European business from an investors standpoint.

So when a high-value British company such as ARM, which designs 90% of the chips in our smart-phones, decides to list in New York rather than on its own domestic market (London in this case), it makes no material difference to the multiple that it achieves.

Regrettably, it’s decision to list in New York simply adds another high multiple business to the U.S. indices and pushes the average valuations on U.S. exchanges further from their European counterparts. That is a terrible shame.