The Quality Series · part 10 of 13
“Buy world-class businesses. Don’t overpay. Let compounding do the work.” That, in one line, is what I do. Most of this series so far has been about the first part. This one is about the second, and in my experience, it is the part most likely to get overlooked once an investor identifies a company they admire.
I’ve always believed that all investing is expectations investing. A share price is simply the cash a business produces, multiplied by what the market is willing to pay for that cash: the multiple. And the multiple is really the market’s expectation of future growth, already baked into the price. When those expectations are too high, even a small disappointment, a soft quarter or a slight miss, can knock the multiple down hard, even while the business itself is doing just fine. It works the other way too. When expectations are too low, the business only has to be less bad than feared for the multiple to go up.
When I wrote up Lam Research in 2018, the market was valuing it at about five times EBITDA; at its peak in mid-2026 it was nearly 70 times, and today it is about 28.
In the spring of 2013, Apple traded at under ten times earnings, about five and a half once you took out its cash, priced almost as if it were going out of business. Today it trades at about 39 times earnings.
Multiples can swing that far, and the low points come round more often than people think.
The example I always use for the mistake of overpaying is Coca-Cola, which I wrote about in my February 2019 article. In 2000 it was one of the finest businesses in the world. The shares were $32, and the whole company, debt included, was valued at around sixty times its free cash flow. By early 2006 the shares were about $20, at under eighteen times. Nothing had gone wrong with the business. The price had simply run far ahead of it, and anyone who bought in 2000 lost about 40% over six years waiting for the business to catch up.
It doesn’t take a bubble for this to happen. Mastercard, which you met in part 4, ran up to about 55 times its free cash flow in 2020 and then went nowhere for two years while the cash flow caught up.
So how do I decide whether I’m overpaying? Because the businesses I own are predictable, I can estimate their free cash flow per share three to five years out with reasonable confidence. I put a conservative multiple on that number, compare the projected price with the current price, and ask one simple question: can this stock comfortably double in five years? That’s roughly 15% a year. I keep the forecast realistic. The caution goes into the multiple.
Lam Research is a good example of this working. When I published my October 2018 write-up, Lam had earned about $13.20 a share over the previous twelve months, and the shares were $141.27, about 11 times those earnings. I projected $15 by October 2020 and put a multiple of 20 on it, which gave me a target of $300. By October 2020, trailing earnings were $15.12, within 1% of what I had projected two years earlier, and the shares had reached about $365. That is what predictability gives you. In July 2020 I raised the target to $500: $25 of earnings per share by June 2022, at the same multiple of 20. By the quarter ended June 2022, earnings had reached $32.75, 31% more than I had assumed, and the $500 had already been passed by the end of 2021, well inside the two years I had allowed. Both times I was conservative on the multiple, not on the earnings: by October 2020 the market was already paying about 24 times those earnings, more than double the 11 times it had paid two years earlier. (All figures are before Lam’s ten-for-one share split in 2024.)
Buffett said time is the friend of the wonderful business. I would only add: not if you bought it at the wrong price.
Next: how I tell a passing problem from a permanent one — the decision that makes or breaks a buy at a setback.
The series so far
- Part 1: The whole idea, in one line
- Part 2: Same five years, very different businesses
- Part 3: From great business to great investment
- Part 4: Where stock returns actually come from
- Part 5: The secret sauce
- Part 6: Why return on capital decides it
- Part 7: A moat is the power to raise prices
- Part 8: Three engines, and the people driving them
- Part 9: What I won't own
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This is my personal investing journal, written for information only. It is not investment advice or a recommendation to buy or sell any security, and it does not take account of your circumstances. I may own shares in companies I write about. Past returns are no guide to future returns.
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