# Looking into the future of a stock

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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That is very persuasive thinking, Saul.

It seems to be a rare find to find a company like SWKS that has experienced explosive growth, not by buying other companies one after another as DDD has done, but rather ORGANICALLY and using proprietary technology that has become integral to so many big time companies.

When the numbers are as good as the story, as the case seems to be regarding SWKS, odds are awfully good that the investor can make money.

I am persuaded. Thank you Chris and Saul.

Jim

2 Likes

Saul,
Excellent, thoughtful post…really explains your investing style.

SWKS is already about 28% of my portfolio. When I think of selling some I talk myself out of it. Buy more? I realize it’s my decision but all comments welcome

Thanks!

Andy

Just for the fun of it, let’s take the same look at INBK’sfuture. They currently have a PE of 18 and a trailing rate of earnings growth of 49% - which gives them a very low 1YPEG of 0.37.

But it’s even better than that. The last four quarters earnings have risen sequentially by 9, 6, 4, and 14 cents, or an average of 8 and a quarter cents. If we assume they slow down and rise by just 5 cents in each of the next four quarters, a year from now their trailing earnings will be up 83% year over year.

Let’s see what that looks like. Start them with imaginary earnings of \$1.00, like all the rest. At a PE of 18 they’d have a price of \$18.00. Now, in a year they’d have earnings up (at least) 83% in our assumption, which would be \$1.83. At a PE of 19, which is quite low for any company growing earnings at 83%, their stock price would be 19 times \$1.83, or 34.77, which is up 93% from the price of \$18 we just started them at. And a PE of 19 with a rate of growth of 83% would give them a 1YPEG of 0.23, which is incredibly good.

Now, this is a tiny company, subject to all the risks of the banking industry, which we have tried to balance by taking just a 5-cent gain per quarter average. Sure, if there is a banking catastrophe, they will be hurt bad. But if there is a banking catastrophe, not only they, but every other company in the US and maybe the world will be affected. At any rate, their expected 93% expected gain in the next year gives them a lot of leeway for untoward events and still allows them to do quite well.

Saul

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SWKS is already about 28% of my portfolio. When I think of selling some I talk myself out of it. Buy more? I realize it’s my decision but all comments welcome

Hi Andy, 28% is a lot! I wouldn’t buy more. Think of non-business things that could happen. A fire or a tornado in one of their main factories, or that kind of thing. Plane crash that kills three of their best R&D guys on their way to a conference, etc. Granted unlikely, but still…

Part of it depends on your age and how much you are investing. If you are young and able to add more each month to replace freak losses, you can concentrate more, but if it was me, I’d just let it accumulate from here. There are other good stocks.

saul

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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…)

This reminded me of the story of a little dunce. Town folk used to make fun of him. They would offer a nickel and a dime and he would always take the nickel. Dumb kid! A good Samaritan, trying to help, asked him why he picked the lower valued coin. “I won’t get to collect a lot of nickels or dimes if I were to pick the dimes.”

It’s obvious that if you can buy a stock at half the P/E you are better off than buying it at the higher price. I can’t believe that TMF is so dumb they don’t know that. The “mantra” must have another twist.

Today it is recognized that growth creates value, that’s why people use the PEG ratio to adjust the P/E ratio by the growth. Anyone who won’t buy stocks with a P/E ratio above the market’s P/E ratio of 15 or so is going to miss a lot of opportunities. I believe that is what the “mantra” is saying, don’t be afraid of P/Es just because they are higher than the market average.

Of course, what you say remains true, the higher the P/E ratio the higher the risk but so is the expected reward, up to some point. For me there is a comfort zone for higher than average P/E ratios provided there is an above average expectation of growth. The interesting thing about growth is that it has a predictable pattern, the “S” curve. This applies not just to stocks but to all manner of things that grow in nature.

Dinosaurian Growth Patterns & Rapid Avian Growth Rates
http://bio.fsu.edu/~gerick/graphics/fig2.jpg

from Dr. Gregory M. Erickson’s Dinosaur Growth Page.
http://bio.fsu.edu/~gerick/dinogrowth.htm

For technology adoption the “S” can be divided into three equal parts: 1/3 slow initial adoption up to around 15% market penetration, 1/3 fast growth until around 85% market penetration and the last third until the end of the technology. If the above scenario is true, you wait until “the curve in the hockey stick” to start buying. You buy even at high P/E ratios until about 50% market penetration. Then you start selling off because the P/E contraction is coming.

It is often said that you can make more money in value than in growth stocks. What one needs to understand is the peculiar dynamic of growth. If you wait until everyone has bought the gadget just to be sure it is a grow product, sorry buddy, not only did you miss the boat, you are buying during P/E contraction! But if market penetration is under 50%, don’t be afraid of high P/E ratios, within reason, that is.

But there is a caveat. During bubbles prices do get ahead of themselves. On must learn to distinguish between TALC (technology adoption life cycle) and the Gartner hype cycle

This is what happened to 3DP!

Look at Intel: http://invest.kleinnet.com/bmw1/stats35/INTC.html

During 1990, with the PC well established but with still a low market penetration, it was safe to buy at a higher than usual P/E ratio. Ten years later that opportunity had vanished. Since 2009 Intel became a value stock, you would have earned a market average gain of around 15%

Denny Schlesinger

7 Likes

Saul,
Sounds like you are drinking your own Kool-Aid on INBK. The reason their trailing earnings growth is strong is simple: earnings were weak last year. Forward earnings growth will be nowhere near that high. Long term earnings growth will trend to approximately 10-15%, as that is the typical ROE that consumer banks can earn.

For technology adoption the “S” can be divided into three equal parts: 1/3 slow initial adoption up to around 15% market penetration, 1/3 fast growth until around 85% market penetration and the last third until the end of the technology. If the above scenario is true, you wait until “the curve in the hockey stick” to start buying. You buy even at high P/E ratios until about 50% market penetration. Then you start selling off because the P/E contraction is coming.

You made some good points in your post. It appears that SWKS is in the hockey stick phase with full year over full year TTM EPS growth of 75%. Based on them hitting guidance for the 6/30/15 quarter, they will maintain the 75% growth next quarter. Yet the P/E is only 22. If their 75% annual EPS growth is maintained for the next 6 quarters then their stock will be at \$223 in early Nov 2016 assuming the P/E stays at 22. If their growth slows and the TTM EPS growth slows by about 5% every quarter then their stock price will be at \$180 in early November 2016 (assuming P/E is still at 22). In my opinion, the \$180 target price is at the very low end of my target price estimate range in Nov 2016.

Chris

5 Likes

Low PE stocks are much safer.

Saul,

Your post is brilliant. You have explained with examples why a low P/E stock is much better than a high P/E stock when their 1YRPEG is the same! This is also what Peter Lynch has said in his book One Up on Wall Street.

I think this concept is difficult for some people to grasp and may be one why why people are attracted to to high EPS growth stocks. The reason this is true, which I think you illustrated in your post, is that a lower growth rate is so much easier to maintain over a long period of time.

P/E=20 with TTM EPS Growth=40% is better than P/E=40 with TTM EPS Growth=80%

AND

P/E=15 with TTM EPS Growth=30% is better than P/E=20 with TTM EPS Growth=40%

And even better:

P/E=10 with TTM EPS Growth=20% is better than P/E=15 with TTM EPS Growth=30%

Given the same 1YRPEG, the lower the P/E the safe the continued growth rate can be achieved and the safer the stock price appreciation can be maintained for longer.

Chris

6 Likes

Thanks Chris,

But what if PE of 10 and TTM EPS growth of 20% just isn’t enough growth for you? then you have to take more risk.

What I thought was most interesting was what happened to the 45 PE stock that was growing at 45%, when the growth slowed. Wow!

Saul

2 Likes

But what if PE of 10 and TTM EPS growth of 20% just isn’t enough growth for you? then you have to take more risk.

Well, that’s interesting. I guess there are 2 ways to look at this.

1. Buy low P/E stocks with low PEGs that will be able to maintain their growth rate for many years. I think that such stocks are very rare and probably don’t exist (or not for long) because the assurance of a consistently high growth rate will drive up the valuation because such consistency is highly valued by investors. Take CELG for example: it has a consistent growth rate yet it’s PEG is above 1.0. Imagine if CELG with a consistent growth rate of 22-25% had a P/E of 11-12.5! Would that be a great buy!

2. A very high growth rate is very difficult to maintain so as Denny pointed out, one needs to exit the stock because EPS growth percentage slows and you get P/E compression. I think that this is the extra “risk” that you are talking about…the risk that the growth rate will slow.

Chris

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The danger in the growth rate compression is relative, however. If you are climbing on the S curve immediately after the start of the upward rapid growth, then the time one has before reaching the point where there is slowing growth depends on the size of the market and the speed of the growth relative to that market. If it is the sort of product where most people who will ever get one will have one in a couple of years, saturation could come quickly. But, if it is a market where the possible upper bound keeps getting higher, then one might have quite a few years of high growth before things level off. In this latter case, one might see some gradual compression along the way just because of the law of large numbers, but it might be less dramatic than one would see if a market were becoming saturated.

Saul,

I am still working but well into social security age so a short work horizon ahead.

All things being equal, which they are’t of course, any stock you favor right now? I have as my biggest positions, no particular order, after SWKS come AMBA, SKX, CRTO, BOFI, than in the next group INKK, SYNA, SNCR, TASR, CELG, EPAM, PANW,XPO

You’re analysis is lucid and brilliant. Seems like an uncomplicated way to invest and do really well; reduces the anxiety of investment decisions

Thanks.

Andy

P/E=20 with TTM EPS Growth=40% is better than P/E=40 with TTM EPS Growth=80%

AND

P/E=15 with TTM EPS Growth=30% is better than P/E=20 with TTM EPS Growth=40%

And even better:

P/E=10 with TTM EPS Growth=20% is better than P/E=15 with TTM EPS Growth=30%

Now to prove that this is true, let’s take it all the way down to P/E=1 and Growth Rate=2%. Now, who wouldn’t pay \$1 to earn \$1 this year, \$1.02 next year, \$1.04 the year after and so on. What you are basically getting is the opportunity to buy the whole company and receive your whole investment back at the end of the year PLUS the opportunity to earn that amount adjusted for inflation every year thereafter.

Chris

1 Like

You made some good points in your post. It appears that SWKS is in the hockey stick phase with full year over full year TTM EPS growth of 75%. Based on them hitting guidance for the 6/30/15 quarter, they will maintain the 75% growth next quarter.

Thanks Chris but there is one point I’d like to warn you about: Market penetration has to do with revenue, not earnings. They might currently be growing earnings at 75% but revenue is growing slower at 59% and 58% in the first two quarters of 2015. While expanding margins are wonderful they cannot outpace revenue growth for ever. WalMart and Dell are two great example of companies that squeezed costs out of their operations to the max yet Dell still ran into problems – the market shifted to tablets and smart phones! (I don’t really know what caused Dell to collapse.)

Anyway, for “S” curve growth expectations I’d rather watch revenue rather than earnings.

Denny Schlesinger

2 Likes

What I thought was most interesting was what happened to the 45 PE stock that was growing at 45%, when the growth slowed. Wow!

Saul

In line with your thinking, Geoffrey Moore explained in The Gorilla Game why fast growing Gorillas can easily have 50% drops on their stock price. The high ratios act as leverage for good and for bad.

Denny Schlesinger

Market penetration has to do with revenue, not earnings. They might currently be growing earnings at 75% but revenue is growing slower at 59% and 58% in the first two quarters of 2015. While expanding margins are wonderful they cannot outpace revenue growth for ever. WalMart and Dell are two great example of companies that squeezed costs out of their operations

Denny, another great point! Let’s consider SWKS again. Their gross margins last quarter were 46.2% but they said on the last conference call that we should expect 48% next quarter and 55% gross margins on their new business going forward. This means that their intermediate term (next 1.5 to 2 years) gross margins should approach 55% (i.e. going up slowly toward that number. In addition, as they grow revenue their operational expenses should declines as a percentage due to scaling up the business. Thus, the bottom line will be enhanced by these two factors (i.e. higher gross margins and higher operational leverage). For this reason, I suspect that they may be able to continue to maintain their 75% full year over full year adjusted EPS for perhaps a while longer. Thus, I think that the low case of full year over full year EPS growth of 75% declining by 5% in each of the next 5 quarters after next (which has guidance maintaining the 75% from last quarter) is very conservative. Furthermore, I think that keep the P/E at 22 given such explosive growth is also conservative. The repeat these conservative (IMO) calculations result in a stock price of \$180 in Nov 2016. If you take a more aggressive view and have the TTM EPS growth rate maintaining at about 75% and a P/E expansion to 25 then you get a stock price of about \$250 in Nov 2016. Again just my opinion.

Chris

3 Likes

All things being equal, which they are’t of course, any stock you favor right now? I have as my biggest positions, no particular order, after SWKS come AMBA, SKX, CRTO, BOFI, than in the next group INKK, SYNA, SNCR, TASR, CELG, EPAM, PANW,XPO

Hi Andy, I don’t know anything about TASR or PANW, but assuming you mean INBK, I like all the rest of your positions, and having SWKS, SKX, BOFI and CRTO among your largest positions obviously makes sense to me as they are among my biggest too.

Saul

Saul,

Thanks.

I did mean, INBK

Best,

Andy

Furthermore, I think that keep the P/E at 22 given such explosive growth is also conservative.

My guess is that the “low” P/E ratio comes from the fact that they sell mostly commodity type products. Years ago I was following International Rectifier (IRF) and they had a wild ride that ended in a takeover.

http://www.irf.com

Should the P/E ratio go much higher I would consider taking profits – just in case… Saul doesn’t like high P/E ratios for good reason!

Denny Schlesinger