Here’s a great video by Michael Mauboussin in which he highlights five common mistakes that investors make. These are:

1. “First is it is really important to try to minimize your own mistakes.”

2. “The second big mistake is the failure to understand regression toward the mean.”

3. “The third big problem is overconfidence.”

4. “The fourth big problem is relying too much on multiples.”

5. “The fifth and final mistake is a failure to compare effectively.”

If we dig a little deeper on point number 4 – Relying Too Much On Multiples, Mauboussin provides some great insights for investors, saying:

I guess I would start with a very important underlying point, which is multiples are actually not valuation. Multiples are a shorthand for a valuation process. And you know, shorthands are great in life. They save us a lot of time, but they also come with blind spots. And it’s really super important to be aware of those kinds of things.

So what underlies a multiple or what is valuation ultimately about?

Well, valuation is the present value of future cash flows, whether you’re looking at a stock or looking at a bond, or basically real estate or basically anything. So the key consideration that I’d like to introduce in this is understanding the role of return on invested capital. And here’s the basic intuition.

If you make investments in the market that earn a return on invested capital exactly equal to the opportunity cost of capital, right– so I demand 10% and I earn 10%– you don’t deserve any sort of high valuation for that.

Basically, your dollar’s worth a dollar in the marketplace.

By contrast, if you take a dollar and it earns a 20% return versus a 10% opportunity cost, that’s awesome, right? And the more you grow that thing, the more valuable the entity will be, and the valuation should be justifiably high.

Third and finally, if you take that dollar and earned– invested 5% return when the demanded return is 10%, you’re actually destroying value.

By the way, you may be growing earnings, but you’re destroying value.

So the key is that ultimately, multiples hinge on two really important dimensions. The first is the return on capital, cost of capital spread, and you need to understand that and be super explicit about figuring that out, both today and prospectively. And second, and only second, is growth. And growth tends to amplify.

So if you have high returns, growth is really, really good, and the more of it you have, the better. If returns are bad– growth actually amplifies the negative– the faster you’ll spin out of control.

So the key is when thinking about valuation and multiples is to understand where they’re useful, but also understand the implicit limitations, of which there are many.

Here’s the entire video:

(Source: YouTube)

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