Case 018Long pitches and valuationCore

Mervaan Foods, a consumer staple, trades at 35x earnings against a five-year average of 45x. Earnings grow 12% a year and the dividend yield is 1.5%. If the multiple recovers only to 40x over three years, what annual return does the stock offer, and what if it stays at 35x?

Balyasny Asset ManagementNew York · 2024

The situation

Mervaan Foods makes packaged staples: flour, edible oil and spices. It trades at 35x this year's earnings. Over the past five years it averaged 45x, and a colleague is pitching it as a long because it is cheap against its own history.

Consensus expects earnings to grow 12% a year for the next three years. The dividend yield is 1.5%. The portfolio manager asks you to put a return on the pitch rather than an adjective.

Your task

What annual return does Mervaan offer over three years if the multiple recovers to 40x, and what if it stays at 35x? Is cheap against history a thesis?

Quick check

If the multiple stays at 35x, roughly what annual return does the stock deliver?

Worked solution

Try it on paper, then open one step at a time.

30-second answerThe answer to give first

About 18.6% a year if the multiple recovers to 40x, and about 13.5% if it stays at 35x. Earnings growth of 12% and the 1.5% dividend do most of the work. Re-rating from 35x to 40x adds about 4.6 points a year, plus a small compounding term. Without it, Mervaan is a steady compounder, not a bargain, and cheap against its history is a starting point for the pitch, not the pitch.

Step 1How do you turn a multiple view into a return?

Split the price into earnings times multiple, and let each grow. Over three years the price return is earnings growth compounded with the change in the multiple, and the dividend comes on top. Earnings grow 1.12 cubed, about 1.405 times. Moving from 35x to 40x multiplies the price by 40 over 35, about 1.143, which spread over three years is 4.55% a year. Together the price grows about 17.1% a year, and the 1.5% dividend takes the total to about 18.6%.

The relationship
r≈(1+g)(PE3PE0)1/3−1+d=1.12×(4035)1/3−1+1.5%=18.6%r \approx (1+g)\left(\frac{PE_{3}}{PE_{0}}\right)^{1/3} - 1 + d = 1.12 \times \left(\frac{40}{35}\right)^{1/3} - 1 + 1.5\% = 18.6\%
gannual earnings growth, 12%
PE_0, PE_3the multiple today, 35x, and in three years, 40x
ddividend yield, 1.5%, added as an approximation
What it says in wordsThe annual return is earnings growth compounded with the annual re-rating, plus the dividend yield.
Where an 18.6% a year return comes from: mostly the earnings+12.0Earningsgrowth+4.6Re-rating35x to 40x+0.5Growthx re-rating+1.5Dividendyield18.6%Total a yearat 40x
If Mervaan re-rates to 40x over three years, the annual return of about 18.6% is 12.0 points of earnings growth, 4.6 points of re-rating, 0.5 points from the two compounding together and 1.5 points of dividend.
Step 2What if the multiple does not move, or falls?

Run the scenarios, because the pitch rests on the one input you cannot observe. At a constant 35x the stock still returns about 13.5% a year from earnings and dividends; at 30x it returns about 7.9%; back at the 45x average, about 23.3%. A household that buys a flat for its rent, not for a hoped-for jump in local prices, is making the same judgement: the rent is the part you can count on.

The multiple swings the answer; the 13.5% floor is the earningsFalls to 30x7.9% a yearStays at 35x13.5% a yearRecovers to 40x18.6% a yearBack to 45x average23.3% a yearno re-rating: 12% growth + 1.5% dividend
Over three years Mervaan returns about 7.9% a year if its multiple falls to 30x, 13.5% if it stays at 35x, 18.6% at 40x and 23.3% back at the 45x average; the 13.5% line is what earnings and dividends deliver on their own.
Step 3Is cheap against its own history a thesis?

No, and the portfolio manager will say so. A multiple falls for a reason, and the pitch has to name it and argue it is fading. The 45x average may belong to a period of faster growth, lower interest rates or less competition from private labels. If growth has slowed from 16% to 12%, 35x may be the right multiple now. So give the variant view: why growth will hold or quicken, or why the reason for the de-rating is temporary. Then state the risk: if earnings grow 9% and the multiple drifts to 30x, the return falls to low single digits. Close with the judgement: a reasonable compounder whose upside depends on a re-rating you need a specific reason to expect.

Where candidates lose it

The trap is equating re-rating with return: 35x to 45x is 29% upside, so the stock returns 29%. That ignores the earnings growth that does most of the work, and it annualises nothing.

The second is anchoring on the five-year average. An average is not a target, and a pitch built on mean reversion alone gets asked, in the first minute, why the market re-rated the stock in the first place.

What the interviewer asks next

  • What earnings growth does the market imply at 35x if you think the fair multiple for 12% growth is 30x?
  • Mervaan's closest peer trades at 28x with 14% growth. How does that change the pitch?
  • What single data point in the next results would make you add to the position?

Asked at Balyasny Asset Management, Generalist, New York, 2024 (Wall Street Oasis): The process included a stock pitch and questions around my motivation.

Company names and figures are illustrative.