The biggest risk

Dan Ramsden
4 min readDec 10, 2020

Our favored valuation multiples have over time climbed up the income statement ladder, rung by rung, and, before long, we may transcend the income statement altogether.

We used to chart the P/E multiples back when, feeling as though earnings were a close enough cash flow proxy, which then was what we really cared about. D&A, it was implied, was capital investment to replace the old, so that E and FCF resembled one another well enough. In the next phase through the years, when CAPEX was replaced by software builds — a direct income statement item for most — the valuation estimates moved up from E to EBITDA, an updated shorthand for cash flow that mainly only missed on working capital. All items down below it, that is, after the “before” and not a part of the discussion — I, T, D&A — were deemed to be irrelevant, redundant, or, in fairness, too much information for a stock that trades. T was hardly paid by the early growth enterprises, D&A non-cash, and I on debt in tech was nearly non-existent.

Afterwards, adjusted forms of EBITDA and other income statement metrics were discovered, some of which were even close to versions of gross profit, which sits a few line items over EBITDA (i.e., before these expenses have a chance to get subtracted). And now, we do away with all of that, the tortured metrics and adjusted calculations, the footnotes and the caveats that need to be explained. As we got closer, rung by rung, to revenue, or as some like to say, top-line (which in the income statement is exactly where its name suggests), we go straight to the source without a fuss, avoiding all expenses clean and simple.

That valuation metrics are now of the revenue variety may also be for reasons other than momentum in the pattern. Perhaps the other income statement highlights would show up puny or straight negative, thus meaningless while revenue, for public companies at least, will be a growing positive amount. Or it could be the other way around, that all the big expenses and the minus signs are prodded and encouraged by the markets, rewarding the top-line above all. Causes and effects are often circular, and who can really say?

In any case, as this has started to occur, some companies are passing others by in market-driven metrics. For when you can’t climb any further than the very top, the top can still, with creativity, get lifted. For instance, one high-flyer that has entered the Bitcoin trade, books Bitcoin volume (i.e., the dollar value of coins purchased on its platform) as all revenue. Maybe the system was inspired by retailers who hold inventory for sale, and book the marked up items to the revenue account in the course of doing business. In the finance field, however, where the item passes through not even underwritten, the approach might strike some as poetic license. We can see below how beautiful is the effect.

Ticker: SQ

But no matter. Perhaps the market has adjusted for the revenue aggressiveness and valuation factors in the lower growth. And anyway the point of all these observations is bigger than the single case.

Valuation multiples, for as long as markets traded actively, have been a way to gauge the fairness of a price. It is a statement on return potential, or payback, in a sense. All things being equal, and suspending disbelief, a price that is equivalent to a 20x P/E, say, implies that it would take some 20 years to recover one’s investment… if earnings stay unchanged and paid as dividends, in the thought experiment.

We all know this would in real life never happen, but the benchmark is the thing that matters. It establishes a frame of reference, a common ground, some sense of orientation, which in markets as much as anywhere facilitates communication and a way to plan. You might feel comfortable purchasing a stock that would take 20 years to pay you back, in theory, because next week, or month, or year, perhaps, you’d sell to someone else who is ok with 25.

Revenue multiples are no different, as long as these somehow correspond with something grounded. But in some cases now, where the multiple can be as high or greater than 100x next year’s expected number, what does this even mean? That if the company hits that target next — and does so without expenses — it would take 100 years to earn back the investment?

This is oversimplified, I know, but still the point is bigger anyway.

It could be that the market value of the sample company described is fair and reasonable and contains enormous upside. It could be that the accounting treatment of trade volume in the prior illustration is sound and passes all the audit tests and rules in every global jurisdiction. In fact, I don’t doubt either of these things.

The point is that the market may have lost its compass. Prices rise or fall now based on arbitrary benchmarks meant to justify prevailing sentiment, rather than the other way around. When risk is discounted at the risk-free rate, that is a sentiment expression with too many variables to process. Sentiment is much more complicated than bookkeeping or multiples, and there isn’t a good way to quantify it, and, more importantly for the investment process, to predict its future movement.

Today, it seems like our most basic fundamental, which was the title of the prior post, of which this is a sort of sequel.

Related reading:

In an economy that can’t be trusted

The sentimental vista

The most basic fundamental

The third body

Reinterpreting the networks

If it’s not a bubble