Great discussion guys. I hate the higher multiples that appear to be the new normal in some sections of the market, and still refuse to buy into it, sticking with so far with companies whose multiples I could have justified 10 years ago as an investment. As you've alluded to madamswer that has meant that I've missed out on some spectacular bull runs for many businesses whose multiples have increased hugely.
Where MarsC has discussed the expected return to be at least a certain level above the risk free rate to give us a margin of safety, while I can agree with this in theory, because interest rates are so extremely low this leaves us highly vulnerable to even a small change in the risk free rate destroying our valuation. For example at 1% risk free rate and giving ourselves a 2.5% margin on expected return we're allowing a 3.5% expected return. If the risk free rate increases to 3% over the next 3 years this moves our expected return to 5.5% and smashes our valuation to a proportionately much higher degree than if the starting risk free rate was say 4% and we allowed ourselves the same margin. Not only do we expose ourselves in this way to higher interest rates, by using such a low yield of say 3.5% we in general won't have any relevant safety net in the balance sheet of said business, i.e. the lower yield also means a higher multiple compared to book value, which leaves us more vulnerable to a downturn in earnings for said business, with the net asset value on the old multiples being closer to the market cap, there was not as far to fall to get to the net asset backing (this net asset backing is not always highly relevant, but can be depending on the quality of the assets on the balance sheet). For this reason, although it now appears archaic, and may mean I'm left behind by the modern market if interest rates do stay this low for a long time, I still refuse to pay the high multiples attributed to many quality businesses on asx and am still anchored to the old pe multiples as being more reasonable as they leave us less vulnerable to either an increase in interest rates or a downturn in earnings. While I wouldn't try to forecast interest rates or inflation, and bond investors as a general rule are a lot smarter than I am, I do see genuine signs of inflation potentially increasing significantly in the coming years, for example higher steel prices are already starting to add significantly to building costs (a quote we had recently on a $1m + build indicated that build costs had increased by more than 25% compared to 18 months ago, I'm not sure if that is across the whole sector but imagine it probably is), it is hard to imagine electricity prices staying this low with coal prices surging the way they are and the job market seems to be tightening in the areas that I pay attention to, which could potentially indicate wage inflation may occur.
Food for thought and didn't intend to derail the conversation. I like arb as a business but like most other high quality businesses on asx at the moment it is too richly valued for me, in large part because I refuse to value these businesses using such a low acceptable yield (perhaps I'm refusing to accept the new normal, we will see).
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