We Study Billionaires – TIP775: Why Your Valuation Metrics Might Be Lying to You w/ Kyle Grieve

Episode Overview

In this solo episode, host Kyle Grieve offers a deep dive into the work of Michael Mauboussin, a leading thinker in the world of investing and decision science. Drawing on Mauboussin’s “Consilient Observer” articles, Kyle explores the pitfalls and limitations of traditional valuation metrics, how investors can improve judgment and decision-making, and the enduring traits of long-term winning businesses. He challenges popular investing myths and provides practical frameworks and checklists for smarter analysis.

Key Discussion Points & Insights

1. The BIN Framework: Reducing Forecasting Errors (02:18–15:00)

Michael Mauboussin's BIN framework (Bias, Information, Noise) offers a structured way to improve judgment and forecasts.

• Noise:

  • Most important in investing decisions.
  • Example: When 50 accountants calculate taxes for the same household, result variability (“noise index”) exceeded 20%—ideally, it should be closer to 10%.
  • Quote:
    "Many, many of the judgments made by professionals are highly, highly variable." (03:30)
  • In markets, dispersed opinions create opportunity for investors, especially when sentiment diverges from fundamentals.

• Combating Noise: Three Techniques:

  1. Combine Judgments: Pooling independent opinions (as Ray Dalio advises) helps offset individual blind spots.
  2. Use Algorithms (Checklists):
     • Enforces thoroughness and consistency.
     • Forces focus on less attractive but impactful aspects.
     • Helps avoid repeated mistakes by incorporating personal investment errors into the checklist.
     • Builds conviction and variant perception.
  3. MAP – Mediating Assessment Protocol:
     • Define key business assessment criteria.
     • Score each criterion (e.g., growth, margins, management).
     • Aggregate scores for objective decision-making.

• Bias:

  • Combat by using base rates; the “outside view” reflects what usually happens, grounding expectations.
  • Retail investor returns (~2.6% annualized) lag well behind market indexes.
  • Optimism bias: Most think they’re better than average stock pickers.

• Signposts:

  • Identify objective, measurable milestones confirming or negating your investing thesis (“kill criteria” à la Annie Duke).
  • Avoid vague language—use quantifiable metrics.

2. Examining Popular Investing Myths (15:00–29:00)

Drawing on Mauboussin’s 2020 Greenwich Roundtable address, Kyle unpacks four central market myths:

(a) Myth 1: The Deleterious Effects of Short-Termism

• Contrary to the belief that markets focus on the short-term, expensive valuations show markets price in long-term future cash flows.
  • Analysis: Only 11% of current equity value comes from dividends over the next 5 years; 89% comes from flows beyond 5 years (e.g., Amex, Coke, MSFT, Merck, P&G).
  • Turnover: While transaction costs fell and trading rose (1975-1985), turnover has declined in the last 20 years—possibly due to rise in passive investing.
  • Quote:
    "My mind typically would agree with the myth, but the data is compelling, especially the decreased turnover point." (20:13)

(b) Myth 2: The Centrality of Dividends in Returns

• While dividends contribute, price appreciation is what actually increases your capital.
  • Quote:
    "It is quite clear that dividends play a role... but price appreciation is the only source of investment returns that increase accumulated capital." (27:53)
  • Investors must reinvest 100% of dividends to match index returns—rare in practice.

(c) Myth 3: Money-Losing Businesses Are Bad Investments

• Some “losses” reflect valuable reinvestment (e.g., Walmart’s negative free cash flow for 15 years due to high-return opportunities—resulting in outsized long-term returns).
  • GAAP accounting often hides such value due to expensing intangibles (R&D, etc.).
  • Adjusting for intangibles reveals true economic picture (e.g., AppFolio, Constellation Software).

(d) Myth 4: Indexing Makes Active Management Easier

• As “closet indexers” exit, competition among remaining active managers increases—making outperformance harder, not easier.

3. Good Losses vs. Bad Losses and GAAP vs. Non-GAAP (29:00–41:57)

• GAAP can obscure true economic reality of businesses, especially in intangibles-heavy sectors (tech, R&D, software).
  • 95% of S&P 500 companies report non-GAAP numbers; ~33% of Russell 3000 reported GAAP losses in 2021.
• Gap Losers vs. Real Losers:
  • “Gap losers”’ losses disappear when intangibles are capitalized appropriately.
  • Example: Adjusting for intangibles flipped 40% of GAAP losers into profitable firms.
  • "Gap often wrongly punishes businesses based on specific accounting principles." (40:15)
• Shareholder Returns Analysis: 1980–2018, “gap losers” (after adjustment) had higher returns than “real losers” or even “winners” in the later period.
  • Amazon’s massive R&D spending was “hidden” under GAAP but crucial for its success.
  • Adjusted P/E drops from 51x to low 20s after adding back R&D (as of Feb 2025).
  • Strategic R&D outlays decrease tax liabilities, fueling more growth.

4. The Problem With Traditional Valuation Multiples (45:04–1:11:00)

Why Your Valuation Metrics Might Be Lying to You

• Multiples (P/E, EV/EBITDA) have become less informative due to rise in intangibles:

  • Numerator (Price or EV) reflects long-term expectations.
  • Denominator (Earnings, EBITDA) is recent—and increasingly distorted by expensed intangibles.
  • Example:
    • Microsoft’s 2023 net income, when adjusted for intangibles, increases by 14.7%.
    • Adjusted EBITDA up 43.6%.
    • P/E drops from 35 to 30; EV/EBITDA from 24 to 17.

• Comparability Problem:

  • Adjustments must be apples-to-apples across peers (e.g. compare adjusted Microsoft to similarly adjusted Google, SAP, IBM, Oracle).
  • Differences can come from:
    • Capital Structure (Debt)
    • Tax Rates
  • Example:
    Walmart and Apple—similar P/E in 2024, but Walmart looks cheaper on EV/EBITDA due to higher debt and tax rate. Prefer companies with superior balance sheets.

• Adjusted Earnings Measures:

  • Companies use different add-backs; not all legitimate.
  • Stock-based compensation (SBC) is contentious:
    • If SBC is low, no significant adjustment; if high, signals underlying dilution/costs.
    • Berkshire Hathaway example: $23B GAAP loss vs. $30.9B operating profit in 2022—due to non-operating investment swings.

5. Beyond Multiples – Prioritizing Growth, Capital Efficiency & Moats (1:11:00–1:22:00)

• Growth Prospects:

  • “Rule of 40” for SaaS companies—revenue growth + EBITDA margin ≥ 40% = healthy.
    • Two equally valued businesses (EV/EBITDA 30x) with different margin trajectories will have very different actual values in a few years.
  • Capital Efficiency:
    Focus on return on invested capital (ROIC), not just headline multiples.

• Temporary Setbacks vs. Secular Declines:

  • Understand if a business’s fundamental declines are temporary (opportunity) or permanent (risk).

• Fundamental Takeaway:
  "The goal isn't to avoid multiples altogether, but to use them with just greater awareness."

6. Corporate Demographics: Business Survival and Wealth Creation (1:22:00–end)

• IPO Trends: Public company births down sharply since 2000.
  • Regulatory costs, access to private capital, M&A preference reducing IPOs.
• Median Business Lifespan: Now about 10 years.
  • Just 5% of public companies survive 50+ years.
  • Survivors tend to have strong moats, adaptability, and high capital efficiency.
• Modes of Business Death:
  1. M&A (58% of de-listings, often at a premium),
  2. Bankruptcy or regulatory delisting (~39%),
  3. Voluntary delisting.
• Why Indexing Works:
  • 2% of stocks account for 90%+ of market wealth creation.
  • Most stocks underperform 1-month treasuries.
• Advice for Stock Pickers:
  1. Remember most companies won’t survive forever.
  2. Adjust valuation models for corporate mortality.
  3. To beat the market, you must select and hold on to future winners.
  • Quote:
    "If you pick stocks, you will need to select future winners, but more importantly, you have to hold them while they continue winning." (End)

Notable Quotes & Memorable Moments

• On Noise & Variability in Professional Judgment (03:30):
  “Many, many of the judgments made by professionals are highly, highly variable.”

• On Price Appreciation vs. Dividends (27:53):
  “Price appreciation is the only source of investment returns that increase accumulated capital.”

• On Misleading Valuation Metrics (1:05:23):
  “It’s intellectually dishonest not to make the same adjustments for every company if you want an apples-to-apples comparison.”

• On Why Most Companies Don’t Survive (1:18:42):
  “The base rates for long-term business success, or even just survival, tend to be quite low.”

• On Indexing and Outlier Wealth Creation (1:24:38):
  “About 60% of companies underperform one-month treasury bills, and only 2% of stocks account for 90% plus of market wealth creation.”

• On the Psychological Challenge of Long-term Winners (1:26:12):
  “If you pick stocks, you will need to select future winners, but more importantly, you have to hold them while they continue winning.”

Timestamps for Key Segments

• BIN Framework, Reducing Noise: 02:18–15:00
• Investing Myths: 15:00–29:00
• GAAP vs. Non-GAAP & Good vs. Bad Losses: 29:00–41:57
• Valuation Multiples’ Limitations: 45:04–1:11:00
• Growth, Capital Efficiency, and Moats: 1:11:00–1:22:00
• Corporate Birth, Death, and Wealth Creation: 1:22:00–end

Final Takeaways

• Traditional valuation metrics can be deeply misleading in the modern economy; always adjust for intangibles where relevant and use qualitative judgment alongside quantitative metrics.
• Long-term investment success requires humility, a deep understanding of business drivers, and the psychological strength to hold emerging winners through volatility.
• The real challenge isn’t just picking winners—it’s holding them, and recognizing when to move on from losers.
• For most investors, especially those not able or willing to do deep company analysis, indexing remains the most reliable strategy due to outlier-driven wealth concentration.

Host: Kyle Grieve
Guest/Source: Michael Mauboussin (via analysis and summary of published articles)

For more, connect with Kyle on Twitter @Rational_MrKTS or LinkedIn (“Kyle Grieve”).

This summary was created for those seeking a comprehensive breakdown of TIP775 without audio. For further learning, explore the show notes or the referenced Consilient Observer articles.