Companion variables

A valuation multiple on its own does not say whether a stock is cheap. Rs 50 could be a bargain or a trap, and the multiple alone cannot tell the difference.

What separates the two is the fundamental the multiple should be compared against — the growth rate behind a P/E ratio, or the return on capital behind an EV/EBITDA multiple. The workbook calls these fundamentals companion variables: the relevant, related numbers a multiple needs to be read alongside before it means anything.

The workbook introduces the idea right after its dividend-yield table: at a price of Rs 50, a stock yielding Rs 5 in dividends has a dividend yield of 10% and a price-to-dividend ratio of 10x; at Rs 200, the same Rs 5 dividend gives a yield of just 2.5% and a ratio of 40x. Whether either price is actually attractive depends on comparing that yield to something else — the workbook uses the prevailing bond yield as the comparison point.

It then generalises the idea: "Like P/E ratio is related to growth rate, or the ROE of the firm, similarly EV/EBITDA is related to the ROI[C]." The companion variable is whatever fundamental explains why a multiple is high or low, so an analyst can tell a genuine bargain from a business that deserves its cheap rating.

Two companies both report EPS of Rs 10. A Ltd trades at Rs 120 (a P/E of 12x); B Ltd trades at Rs 140 (a P/E of 14x). On the multiple alone, A Ltd looks like the better buy — it is cheaper per rupee of earnings.

Now bring in each company's companion variable, its growth rate: A Ltd is expected to grow earnings at 10% a year, B Ltd at 15%.

A Ltd:  P/E 12x ÷ growth 10 = PEG 1.2x
B Ltd:  P/E 14x ÷ growth 15 = PEG 0.93x

Once growth — the companion variable to P/E — is factored in, B Ltd turns out to be the cheaper stock despite its higher headline multiple.

Chapter 10.7.1, immediately after the dividend-yield-versus-bond-yield comparison, is where the term "companion variables" is introduced by name. The idea then runs through the rest of Chapter 10 without always being named — the PEG ratio (10.7.3) and EV/EBITDA-versus-ROIC comparisons are both direct applications of it.

• The workbook does not give a single formula for "companion variable" — it is a way of thinking about a multiple, not a ratio with its own numerator and denominator. Do not expect a standalone computation question on this term; expect it embedded inside a PEG ratio or EV/EBITDA question.
• A low multiple with a weak companion variable (low growth, low ROIC) is not automatically cheap — it may simply deserve to trade low.