The Conundrum of Expanding Multiples

 | Mar 27, 2013 | 12:05 PM EDT  | Comments
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Why are we suddenly willing to pay 18x earnings for General Mills (GIS) when we were willing to pay only 15x earnings last year and as little as 12x earnings in 2009?

I am talking about the conundrum of multiple expansion and how we are supposed to simultaneously hate that fact and learn to live with it. Unless you are puzzling now over this very issue, I think you are simply not thinking seriously about what's going on in this market.

First, the phenomenon of multiple expansion is not something we should ever be comfortable with. We know that it's totally legitimate to pay more for a stock as its earnings go up. When we decide that a 10% grower like General Mills should get a 15 multiple, then we can match those future earnings streams with that historical multiple and arrive at a price to pay, because in the end, the earnings estimates times the multiple does reveal the stock price.

But how about when we suddenly decide we are going to junk the historical 15x earnings multiple and gravitate, some would save levitate, to 18x earnings? Over the course of just a few months, we have decided not that we should pay up for future growth but that we should pay more for the same growth than we did just a few months ago. That's pure multiple expansion, and we know it should be uncomfortable, because it always feels like you are being like a greater fool when you do. I mean you shouldn't wake up one day and say, "You know what, I am going to pay 19x earnings for General Mills, instead of 18," because implicit in that determination is that someone will come along and pay 19x earnings. If someone doesn't, you should get hurt, as the stock's multiple eventually should revert to the mean.

Or should it?

That's where we are right now. That's what has to be examined. I think there are two ways to look at this. First, you could ask, what has changed about General Mills? And second, you need to ask, what has changed about the world that we are willing to pay more for the future earnings of the one we always affectionately called "Generous Mills" for its bountiful dividend policy, a title that this stock is indeed most worthy of by any stretch of the imagination?

We know that Ken Powell, the CEO, has done a magnificent job of navigating through grain inflation, gasoline inflation, cutthroat competition and a fickle and chary consumer. His slow and steady hand on the tiller is certainly worth a higher multiple than the S&P 500, which currently trades at 15x earnings. So as that S&P multiple goes higher, it is reasonable to think that General Mills should too.

Second, General Mills has been nothing short of remarkable in its dividend payout. In 2018, General Mills paid $0.79 in dividends. Now it pays $1.22. That's just a terrific appreciation. During that time, the market capitalization has gone from $20 billion to $31 billion, so if the stock had stayed at the same market cap during this period, it would be yielding almost 4%.

I think that's the key to the equation. You cannot get a safe 4% yield with 10% growth in this market anymore, because the world is starved for yield, thanks to the low-interest-rate environment, stoked in part by Ben Bernanke. I think the reason we can go from 15x earnings to 18x is that the dividend tax advantage unexpectedly stayed low at the same time as Bernanke committed us to low rates until 2015. It's that, not the earnings, that's driving this machine.

How do we know this? Because you can perform the exact same function for almost every single soft-goods company that's now yielding 3%. Same progression of the dividend, same progression of the multiple to earnings. That's why the step up. Greater fool? No, just greater search for safe dividends that give you a tax-advantaged yield. And that explains the levitation, not the growth of the packaged goods market, and not the lower input costs. That explains the conundrum. That's something we can live with, even up at these elevated levels, at least for now.

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