Your numbers, the target, and the flat-multiple test
A pod pitch is a view on the earnings, not on the multiple. Grow the numbers your way, hold the multiple where it is, and see what return is left.
- Split a target return into earnings growth, multiple change and dividends
- Underwrite a pitch at a flat multiple
- Find the exit multiple a target return quietly requires
- Say why the PM asks for the flat-multiple case first
The intuition
A share price is earnings times a multiple. Over the next year one of those you can have an edge on and one you cannot. Your channel checks, your model of the pricing round, your count of the new stores: those are a view on the earnings. What multiple the market will pay in twelve months is the market's mood, and the mood is mostly the sector and the market, which the hedge in chapter 4 takes out of your book anyway. So the honest target is your earnings on today's multiple.
The multiple bridge makes that discipline arithmetic. Total return = the part from earnings growth, plus the part from the multiple changing, plus dividends. The first bar is the return your work can claim. The second is the market agreeing with you. Run it backwards and it tells you the exit multiple your target needs: if that is above today's, the pitch has quietly become a call on the market's mood.
Price return = (exit P/E ÷ entry P/E) × (1 + growth)^n − 1. Growth at a flat multiple is the part you underwrite; the rest of the price move is the multiple. Exit P/E for a target = entry P/E × ((1 + target)^n − yield × n) ÷ (1 + growth)^n. If that exit P/E is above today's, the pitch needs the market's help.
Why it works
- The conventions here: EPS grows at one rate for n years; the price return is the exit multiple over the entry multiple times the growth; dividends are simple on the entry price; the annual rate is the n-th root of one plus the total. The recipe's holds are three or five years; the pod version is the same arithmetic over the next few quarters.
- Earnings revisions are the pod's alpha. Stocks follow estimates: a company that beats, and whose next-quarter numbers get raised, goes up on the same multiple. That is the return a sector analyst is paid for. A re-rating of the whole sector goes up on the long and down on the short, and cancels.
- Your growth number is a delta against the street. The bridge takes one growth rate; in the pitch, it is yours, and next to it you say what the street has. The difference, times the multiple, is the target's distance from the price.
- The flat-multiple case first. If the return at an unchanged multiple clears the hurdle, the pitch stands on its own and any re-rating is a gift. If it does not, say so: the pitch is a market call, and it should be argued as one or dropped.
- Run it backwards to find the hidden assumption. The exit multiple a target needs is the number most pitches hide. Above today's multiple means "I need the market to pay more per dollar of earnings than it does now"; the PM will ask why it should.
- Dividends are cash and count, but a yield of a few percent rarely carries a pod pitch; the horizon is too short.
| From earnings growth: 1.10³ − 1 | 33.1% |
| Price return: (18 ÷ 15) × 1.10³ − 1 | 59.7% |
| From the multiple: 59.7% − 33.1% | 26.6% |
| Dividends: 2% × 3 | 6.0% |
| Total, and a year: 65.7%, 1.657^(1/3) − 1 | 18.3% a year |
| At a flat multiple: 33.1% + 6.0% = 39.1% | 11.6% a year |
| Exit P/E a 12% target needs: 15 × (1.12³ − 0.06) ÷ 1.10³ | 15.2x |
Nearly seven of the 18.3 points a year are the multiple. The 12% target needs almost no re-rating, so that hurdle is safe; a 15% target would not be.
The formulas
The two things a return can come from, plus dividends.
Multiple change times earnings growth.
The bar you underwrite, and the bar you hope for.
Add dividends, then annualize by the root, not by dividing.
The multiple the target quietly needs.
Worked example
Grow the EPS, apply the exit multiple and compare with the entry price. Then read the bridge the pod way: the growth bar is the flat-multiple case, the part your work can claim; the multiple bar is the market's mood.
See it move
Same stock and the same entry price. Change the entry and exit multiples, your earnings growth, the dividend yield, the holding period and the return the PM wants.
- Raise your earnings growth. The growth bar rises and the exit multiple the target needs falls. Watch the curve: past the point where it crosses today's multiple, the pitch needs no help from the market.
- Set the exit P/E equal to the entry P/E. The multiple bar disappears and the two annual-return bars meet: that is the flat-multiple case.
- Raise the return the PM wants. The exit multiple it needs rises; nothing in the bridge moves, because the bridge describes the stock, not the hurdle.
- Raise the entry P/E with the exit P/E held. The multiple bar falls, because you paid more for the same exit, and the target needs a higher exit multiple.
- Raise the dividend yield. The dividend bar rises and the target needs less re-rating.
Run it backwards
The question a PM asks after your target: what multiple does the stock have to be on for that return? Turn the target into a total return, remove the dividends, and solve for the exit multiple.
The target return compounded over the hold, less the dividends, is the price return you need. Earnings growth supplies part of it; the exit multiple has to supply the rest, so exit P/E = entry P/E × price return needed ÷ growth supplied.
Read the last line as the pitch's honesty check. A re-rating at or below zero means growth and dividends carry the target. A large positive one means the return is mostly the market changing its mind, and the pitch should say so out loud.
Traps
Say it in the interview
“Where does your target come from?”
Check yourself
4 fresh questions, with new numbers. Answer each one correctly to finish the chapter. Get one wrong and you will see the full working, then you can try it again with new numbers.
Answers within 1% are marked right. Type the number; $, %, x and M are fine. First tries count toward Learned: the topic is Learned once every chapter is done and 75% of first tries were right.
- Return = earnings growth + multiple change + dividends. Underwrite the first; treat the second as a gift.
- Target = your EPS × today's multiple. The pitch is your EPS against the street's.
- Exit P/E the target needs = entry P/E × ((1 + target)^n − yield × n) ÷ (1 + growth)^n.
- If that exit P/E is above today's, say so: the pitch needs the market's help.