I’m writing this in response to the bug that Chris put in my ear about how to look into the future of a stock. I’ve been thinking some more about Chris’ question and have done some imagining and calculating. Let’s begin:

Let’s start with imaginary stock **ABC**, which has a PE of 45, but a TTM earnings growth of 45% too, so it has a respectable (but not great) 1YPEG of 1.00. This stock price, at a PE of 45, is inherently unstable because, by the law of large numbers, that rate of growth is going to come down. For example, say this quarter their earnings only went from 30 cents to 39 cents, which is not bad, but “only” up 30%. If that continues for a few quarters and they keep their PE of 45, with their rate of growth at 30%, their 1YPEG will rise to 1.50 and they will appear overpriced. Indeed they’ll BE overpriced.

And note that, in keeping their PE at 45, the stock price rose at the same rate their earnings grew, at only 30%. To get their PE down to 30 their stock price will actually have to grow slower than 30%. It’s a double hit. Here’s the calculation:

Year 1 – Earnings $1.00, stock price $45, PE 45

Year 2 – Earnings $1.30 (up 30%). To get to a PE of 30 we take $1.30 times 30 and we get a stock price of $39!! So the stock price will actually have to fall in the year from $45 to $39 to accommodate the new 30% rate of growth and give a PE of 30!

This is why high PE stocks are dangerous !!! (Yes I know that this is contrary to the MF RB mantra that we should look for high PE stocks…)

The high PE stocks whose PE’s are even substantially higher than their rate of growth (with 1YPEG’s well over 1.00), are even more dangerous. Think of those MF darlings, the 3D printing stocks. I explained that I was out of them because of their high PE’s. Let’s look at what happened to them when people realized they weren’t growing as fast as their PE’s:

**DDD**: from a high of $96 to the current price of $22 (down 77% from the high)

**SSYS**: from $136 to $35 (down 74%)

**XONE**: from $75 to $12.76 (down 83%)

**AMAVF**. It has held up “best” and is down from $49 to $15 or down “just” 69% (and it still has a high PE).

Let’s consider **Facebook**. Before this quarter’s earnings they were at about $82 with trailing adjusted earnings of 1.73 and a PE of 47. This is a high PE! However they were growing trailing earnings at 94%, and thus had a 1YPEG of just 0.50.

But that PE of 47 left them vulnerable. This quarter they just grew earnings at 23.5% (from 34 cents to 42 cents). Their stock price has fallen from $82 to $78.50 in a rising market. Their PE has dropped from 47 to 43.4. Their rate of growth of trailing earnings has dropped to 63% from that 94% we just saw, and their 1YPEG is up to 0.69 from 0.50. **And all that was from just one quarter, not of a loss, but of only 23% growth!** They warn of increased spending this year. Because they are Facebook, people will give them some slack, but you can see their stock price won’t be rising much, if at all, this year.

Let’s do the same calculation for them that we did for the imaginary company ABC. Say they start with the imaginary $1.00 in earnings and their current PE of 43.4. That gives them a starting price of $43.40. If they improve on the first quarter a bit and grow by 25% for the year, they will have earnings of $1.25. If their PE drops only to 38 (because they are Facebook), they will have a year end price of $1.25 times 38, or $47.50, up 9% from the current price of $43.40. Not very exciting.

Now look at **CRTO**. They have a PE of 40, but a trailing rate of earnings growth of 220% (in US$). If their rate of earnings growth drops this year to 120% instead of 220%, they’ll still be fine, because they’ll push the earnings up so much. Let’s do the same calculation for them that we did for our imaginary stock ABC. Start them with earnings of $1.00 for an easy comparison, and imaginary price of $40, giving us their current PE of 40 times earnings.

Now next year, earnings were up 120% to $2.20. Say PE dropped to 35 (actually “low” for a stock growing earnings at 120%). $2.20 times 35 will give them a price of $77 next year, up 92% for the year. They are pretty safe. An earnings growth rate of 220% gives them ample protection for a PE of 40, even if the PE drops by 5 points each year as the rate of earnings growth comes gradually down to earth.

Now let’s look at a low PE stock, **SWKS.** Their PE is 22.4 and their rate of growth of trailing earnings is 77%. Their 1YPEG is just 0.29. However, they seem to actually be accelerating. Their rate of growth of earnings last quarter was 85.5%. Their margins are improving. Their revenue was up 58% organically!!!

Let’s do the same calculation for them. Start them with imaginary earnings of $1.00 for comparison. A PE of 22.4 puts them at $22.40 stock price. Say they grow earnings for the year at a rate between the trailing rate of 77 times and last quarter’s rate of 85.5% - lets say 80%. That will give them earnings for the year of $1.80. With a tiny PE expansion to 25 (quite low for a company growing 80%), their stock price ($1.80 x 25) will be $45, up 101% for the year from $22.40.

Okay, that was what we expect. But how safe are they? What if something goes wrong, and they only grow 50% instead of the 80% we expect? A huge miss.

That gives them earnings for the year of $1.50, up 50% from $1.00. Let’s say their PE drops from 22.4 down to 19 (how low can it go with 50% earnings growth?) and a stock price of 19 times $1.50, or $28.50, which is up 27% on the year from $22.40. If up 27% is the bad news which we consider pretty unlikely, they are pretty well protected by their low PE.

This was just exercising my mind in looking ahead, as Chris suggested. Hope you found it interesting. I think one message is that stocks with PE’s of 45 or more, are quite unstable and dangerous unless they have enormous earnings growth to protect them. Low PE stocks are much safer. The other message is that you can make an intelligent guess about what may happen over the course of the year.

Saul

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