Thought Experiment on the Valuation of Remarkable Companies

This article attempts to answer the following question:

How should we value high quality companies?

These are companies with the potential for sustainably high returns on their investments, which can be measured using ROCE (Return on Capital Employed) or ROE (Return on Equity).

Unfortunately, it's impossible to predict a company's future returns on capital, so we must make an assumption that their average historic returns will continue into the future - that is, the company will be able to make the same percentage returns on each dollar it invests in the future as it has in the past.

This is quite a big assumption; however where investing in companies with a proven and sustainable competitive advantage, it's not completely out of the question that they'll be able to sustain their returns for years into the future.

The MSCI World Index has an average historic Return on Equity of around 11.5% and currently has an average PE of around 23 at time of writing (October 2021). If all profits are retained within the underlying businesses, returns are sustained and the PE ratio remains constant, then you would expect the index to appreciate at a rate of 11.5% per year*.

Now let's consider a hypothetical company, GrowCo, with an ROE of 23%, double that of the market. What would be a realistic multiple to pay for that company when compared with the market? The answer may be surprising.

Using our assumptions above, we would expect the share price of GrowCo to appreciate at a rate of 23% per year. If we assume that the PE ratio will fall to the average PE ratio of the market, currently 23, then over a 10 year horizon, we are able to pay an initial multiple of just over 61 for the company's shares to achieve equivalent market returns. If we believe that the company can achieve the same returns for an even longer period, then this multiple will increase.

This can be demonstrated below:

MSCI World Index: 11.5% per year for 10 years with a constant PE ratio = 197% growth
GrowCo: 23.0% per year for 10 years with a constant PE ratio = 693% growth
GrowCo: 23.0% per year for 10 years, with a 62.5% decline in the PE ratio, bringing it from a PE of just over 61 to a PE of 23 = 197% growth, equivalent to that of the market.

The earnings multiple could reduce by just over 62% during the period to bring the expected share price returns back down to the same level as the market returns. This creates a large margin of safety. These companies are therefore likely to deliver above-market growth over the long term, provided they can sustain their returns.

The conclusion to this thought experiment is that high quality companies, with returns on equity that are sustainable over many years, can command significant earnings multiples and that these companies may actually be good value despite appearing expensive when compared with the market.

Interesting fact: the German word for a 'thought experiment' is Gedankenexperiment, a term used by Albert Einstein to describe his approach of using conceptual rather than actual experiments in creating the theory of relativity.
One of the most famous thought experiments was Schrödinger's cat, which demonstrated that hypothetically a cat may be considered both dead and alive at the same time.
Similarly, I think we have demonstrated here that quality companies can be both expensive and cheap at the same time!

*It should be noted that this will rarely be the case, with many companies paying out some of their profits as dividends or returning capital to shareholders by buying back their own shares. It's unlikely that all profits will therefore be reinvested at the same rate of return.

Note: This article was was also posted on my profile on eToro on 18th October 2021.