Stock prices go up for one of two reasons; earnings growth or multiple expansion. If you really want to hit the jackpot with your investments, try and find stocks that can give you both. The combination of the two, as I will illustrate in a moment, is really powerful in terms of shareholder returns.
This is one of the many reasons why value investing has proven to be so successful over time. By buying stocks that have meager valuations, there is always the potential for multiple expansion. Getting earnings growth is even easier because most economies grow over time, so as long as management teams do a good job, earnings growth is inevitable over the long term.
Last year a friend of mine emailed me about a stock he was looking at, beverage giant Diageo (DEO). Diageo is one of the biggest wine, spirits, and beer suppliers in the world, known for brands such as Smirnoff, Guinness, Baileys, Captain Morgan, and Tanqueray. At the time (perhaps about a year ago or so) DEO shares were trading in the low sixties and the company was expected to earn about $4 per share in the coming year. At about fifteen times forward earnings the stock looked pretty fairly valued to me. Given DEO's size and an organic revenue growth rate of about 6 percent, earnings growth would likely average mid to high single digits, so a fifteen multiple seemed reasonable.
I can't remember exactly what my response to him was, but I suspect my feelings on the stock were something like "yeah, it's a solid defensive play with a nice dividend yield, but it looks fairly priced, so I would expect the stock to pretty much track earnings growth." Well, that assessment turned out to be quite wrong. The stock has risen by more than 30 percent since then, to the low 80's.
So what the heck happened? Simply put, most of the gain came from multiple expansion. Beverage stocks have had a great run lately as they offer fairly predictable profits and nice dividend yields (just look at the charts for BUD, KO, and TAP). Defensive investors have placed a higher value on these stocks lately, and their stocks, which used to fetch market multiple of 14-16 times earnings are now getting 17-19 times earnings. Sales growth is still mid single digits, with earnings ranging from the high single digits to low double digits, but the stocks are seen as safe, and as markets rise, some investors look to put money in less aggressive places.
How much of DEO's gain was due to multiple expansion? Well, they earned $4 per share in 2006 and the stock went from a 15 P/E to an 18 P/E, so that is $12 per share in appreciation due to a higher multiple. That amounts to about a 20 percent share price jump (given that the stock was around $60 per share). Add in another 10 percent or so for earnings growth and you get a stock that is up 30 percent in the last year.
I might have been wrong about Diageo, but this should help to explain why valuation is so important when investing in the stock market. Diageo's business hasn't really changed much at all in the last year, but investors' willingness to pay up for the stock has, quite meaningfully in fact. And that, you see, is the power of multiple expansion.
Full Disclosure: No position in DEO at the time of writing