Money managers could have a new item on their wish list if a
valuation tool that is the subject of a new research paper
lives up to its billing. The tool, known as warranted
multiples, represents a new way of adjusting accounting ratios
for fundamental drivers of risk, profitability and growth.
Surely investors would welcome an additional tool to identify
mispricing of assets based on conventional measures.
That is what authors Jiyoun An, Sanjeev Bhorjaj and David Ng
of Cornell University have produced via their research paper,
Warranted Multiples and Future Returns, which hones
a methodology that merges accounting ratios and fundamental
Think of warranted multiples as synthetic ratios that
display unique variations in growth, profitability and cost of
capital. Genuine peers have similar warranted multiples, as
youd expect. Subtracting warranted multiples from
accounting multiples yields excess multiples. In the next one
to three years, firms with low excess multiples today will
record higher stock returns than firms with high excess
multiples, if history is any indication.
A warranted PE, to take one ratio, comprises industry
average PE, forecast earnings growth rate, leverage, and
research and development as a ratio of sales a ratio
more robust than PE alone. As a window on calculations, compare
warranted and excess PE ratios for Microsoft and Oracle, based
on average current PE, a forecast growth rate using IBES data
for December 2012 and December 2013, leverage equal to
debt/equity, and R&D as a percent of sales.
For MSFT last December 15, the current PE was 9.34 and its
warranted PE was 12.47. The difference between them, the excess
multiple, was -3.13. The result implied undervaluation. Oracle
signals the opposite conclusion. Subtracting its warranted PE
of 12.42 from the current PE of 16.59 yields an excess multiple
of 4.17, a sign of overvaluation.
Differences in performance are statistically and
economically significant and wont show up using other
market risk analysis, including the capital asset pricing
model, according to the authors. Says Ng, What we find is
that if we use excess multiple instead of accounting multiple
to sort stocks, we get better predictability for subsequent
The findings confirm earlier research showing that multiples
based on accounting alone yields misleading results. But the
Cornell trio widened their research to test implications for a
broader array of measures, including enterprise value to sales,
price to book, price to earnings, and price to two-year-ahead
Will the authors expectations pan out? If the future
comports with historical evidence, probably. If Mr. Market
takes an unexpected turn, then maybe not. But as far as tools
for peering ahead at many stocks, in the absence of a crystal
ball, warranted multiples might warrant a close look.