A Pricey P/E

High Pricey P/E

A company may be selling at an exceptionally high P/E because it is considered to have remarkably good prospects for growth.

No matter how high the quality of the car you are looking at, there is a price at which it is no longer worth buying.  No matter how junky a car is, there is a price at which it is a bargain.  Stocks are no different.

Some stocks with high multiples work out, but investors who consistently buy high multiple stocks are likely to lose money in the long run.

Often the highest multiples are present in a bull market which increases the risk.  

Graham and Dodd observed, " It is a truism to say that the more impressive the record and the more promising the prospects of stability and growth, the more liberally the per-share earnings should be valued, subject always to our principle that a multiplier higher than 20 (i.e., 'earning basis' of less than 5%) will carry the issue out of the investment range."

It is not wrong to pay more, Graham and Dodd noted; it is simply that doing so enters the realm of speculation.

What free cash flow tells you

What free cash flow (FCF) tells us that earnings don't?

Let us have a look at Company ABC.

From 1995 through 1997, the company posted $100,000, $5.9 million, and $12.3 million in earnings.  Nice growth, right?

The company's FCF, by contrast, was negative $7.0 million, negative $28.0 million, and negative $57.4 million.  FCFs also grew - but in the opposite direction as earnings.

That's not necessarily bad.

FCF is equal to the cash a company generates minus the amount it invests.

Company ABC is investing a lot, which is why its FCFs are negative.



How much is a lot (of capital expenditure)?

A quick way to tell how quickly a company tears through money is to compare its capital spending with its long-term assets (mostly, its plant and equipment).  

While not perfect, the comparison at least gives us an idea of how aggressively a company is spending.  

Company ABC's capital spending as a percentage of its long-term assets has been as high as 43%.  That's a prolific spender.

At the opposite end of the spectrum would be company like Company XYZ, which cruises along spending an amount equal to about 5% of its long-term assets.

When you see a percentage as high as 30% or 40%, chances are you're dealing with a young company just getting on its feet.

Make Millions From Thousands

By Selena Maranjian 
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I could write this article the usual way -- by showing you how to turn your thousands into millions through investments in solid, growing, well-known companies. Union Pacific (NYSE: UNP), for example, has grown by a compound average of more than 12% annually over the past 10 years, whileApple (Nasdaq: AAPL) has averaged 27% over that same period! Not too shabby.

But can such returns turn your thousands into millions? Yes, eventually. An investment of merely $10,000 would turn into $1 million in 30 years, if it grew at an annual average of 17%. But that's a fairly steep rate to count on for your stock investments -- a number to which only a select few master investors can aspire. It's safer to have more conservative expectations -- perhaps closer to 10%, the stock market's historical average annual return over most of the past century.

A fine balance 
So what should you do if you don't want to wait 50 or more years to make millions? Here's one option: Take a few chances.

With most of your money, you shouldn't take crazy risks. You might want to sock much of it away in a broad-market index fund, such as the Vanguard 500 Index (VFINX). That low-cost fund should earn you close to the market's historical return over long periods of time. You might also try S&P 500 Depositary Receipts, an exchange-traded fund also known as SPDRs. Either of these options will instantly invest your money in 500 major American companies, such as Disney (NYSE: DIS) and Motorola (NYSE: MOT).

But once you've done that, take a few chances and supplement your index with growth-stock picks. That's what I'm doing in my own investment account. I don't want all of my money in an index fund, because I'd like my portfolio to grow faster than average, so a chunk of my nest egg sits in a variety of individual stocks.

This strategy should help moderate volatility, and it can also allow you to do well with some carefully chosen stocks -- as it did for me, when I turned $3,000 into $210,000. (It also helped me triple my money in a year.) If you don't believe me, read Paul Elliott on how one stock can change everything. He describes how $1,800, the cost of a fancy TV, can turn into $190,000, the value of an entire home, when you break rules.

Aiming for the stars 
Such returns, which come from classic Rule Breaking companies, are too tempting for me to ignore. That's why I'm still on the lookout for young, dynamic companies that are breaking the rules as they grow and prosper.

The kinds of companies I'm talking about are tomorrow's Google (Nasdaq: GOOG),Amazon.com, and Wal-Mart (NYSE: WMT). Think about how different the world was before them. We would have laughed at the thought of being able to look up almost anything online. We couldn't imagine buying books (and cookware and lawnmowers) on our computers. We wouldn't have been able to find low-cost discount stores in small towns across America. These companies all broke their industries' molds and introduced newer, better systems.

Even Ford was a Rule Breaking company once, too, daring to make a luxury item available to the masses at an affordable price. Just try to imagine a world without cars.

Find a few rockets 
Seeking out and investing in Rule Breakers requires patience and entails risk. However, just one growth rocket has the potential to supercharge an otherwise stodgy index strategy.

This article was originally published on July 7, 2006. It has been updated.

Buffett (1991): Recognise the enormous benefit of the 'double-dip' benefit. Pay a reasonable multiple despite high growth rates.

In Warren Buffett's 1990 letter to shareholders, he touched upon his fondness for doing business in pessimistic times, mainly for the prices they provide. Let us look what the master has to impart in terms of investment wisdom in his 1991 letter to shareholders.

"Coca-Cola and Gillette are two of the best companies in the world and we expect their earnings to grow at hefty rates in the years ahead. Over time, also, the value of our holdings in these stocks should grow in rough proportion. Last year, however, the valuations of these two companies rose far faster than their earnings. In effect, we got a double-dip benefit, delivered partly by the excellent earnings growth and even more so by the market's reappraisal of these stocks. We believe this reappraisal was warranted. But it can't recur annually: We'll have to settle for a single dip in the future."

The master's above-mentioned quote has been put up not to extol the virtues of the two companies but instead to drive home the enormous advantage of the 'double-dip' benefit that he has mentioned at the end of the paragraph. In the stock markets, it is very important to pay a reasonable multiple to the earnings of a company because if you overpay and if the multiples contract despite the high growth rates enjoyed by the company, then the overall returns stand diluted a bit. In fact, it can even lead to negative returns if the multiples contract to a great extent. On the other hand, investing in even a moderately growing company can lead to attractive returns if the multiples are low.

Imagine a company 'A' having a P/E of 25 and a company 'B' having a P/E of 10. Company 'A' is a high growth company, growing its profits by 20% per year and company 'B' is a relatively low growth company growing its profits annually by 12%. Now, two years down the line, because of 'A's growth rate, if its P/E were to come down to 20 and 'B's were to rise up to 12, then we would have in the case of 'B' what is known as a double dip effect. 'B' has benefited not only from the growth but also from the multiple expansion, resulting into returns in the range of 23% CAGR. 'A' on the other hand, despite its high earnings growth has helped earn its investors a return of just 7.3% CAGR. The main culprit here was the contraction in multiples of 'A', which fell to 20 from a high of 25.

This analysis could easily lead to one of the most important investment lessons and that is to pay a reasonable multiple despite high growth rates. For if there is a contraction, all the benefits from high growth rates go down the drain. Little wonder, the master has always insisted upon an adequate margin of safety, which if put differently, is nothing but buying a stock at multiples, which leave ample room for expansion and where chances of contraction are low.

If one were to apply the above lesson to the events playing out in the Indian stock markets currently, then it becomes clear that while the robust economic growth would continue to drive the growth in earnings of companies, most of the good quality companies are trading at multiples, which do not leave much room for expansion. In fact, if anything, the probability of the multiples coming down for quite a few companies is on the higher side, thus diluting the impact of high growth to a significant extent. Thus, we would advice investors to pay heed to the master and wait patiently for the multiples to come down to levels, where the benefits of the 'double dip' effect become apparent.

http://www.equitymaster.com/detail.asp?date=11/2/2007&story=4

Buffett (1989): His view on high growth rates, EBITDA and zero coupon bonds

We saw Warren Buffett make some significant dents in the efficient market theory and also got to know his take on arbitrage. Let us see what the master has to say in his 1989 letter to shareholders.

Have you ever wondered why despite such enormous wealth and infrastructure, the US economy canters at a mere 3%-4% growth rate per annum and why a country like India, which has very little infrastructure in comparison to the US, is galloping at 7%-8% rate. Or better still, what happened to the 40%-50% growth rates that the Indian IT companies notched up so successfully in the not so recent past? The master has the following explanation to these phenomena:

"In a finite world, high growth rates must self-destruct. If the base from which the growth is taking place is tiny, this law may not operate for a time. But when the base balloons, the party ends: A high growth rate eventually forges its own anchor."

Indeed, in a world where resources are limited, consistently high growth rates would create pressure on those resources, thus resulting into either exhaustion of the resources or slowing down of growth. To better illustrate this point, let us return to the Indian IT industry. The demand for qualified IT professionals (a limited resource as we can produce only so much per year) has been so high in recent times that this has resulted in a disproportionate rise in salaries and attrition levels, thus impeding profit growth. Further, it is much easy to double revenues on a base of Rs 500 - Rs 600 m than on a base of Rs 50,000 m - Rs 60,000 m. Hence, those who are expecting these companies to grow at the same rate as in the past, might be in for some real surprise.

Another important topic that the master has touched upon in his 1989 letter is the gradual deterioration in the quality of representation of a company's true cash flow by certain promoters and their advisors in order to justify a shaky deal. While earlier, a company's cash flow, to justify its debt carrying capacity took into account its normal capex needs and modest reduction in debt per year, things had come to such a pass that EBITDA emerged as a substitute for a company's cash flow. Important to note that EBITDA not only excludes the normal capex needs of the company, but it was deemed enough to cover just the interest expense on debt and not the repayment of debt. This is what the master had to say on such practices:

"To induce lenders to finance even sillier transactions, they introduced an abomination, EBDIT - Earnings Before Depreciation, Interest and Taxes - as the test of a company's ability to pay interest. Using this sawed-off yardstick, the borrower ignored depreciation as an expense on the theory that it did not require a current cash outlay. Capital outlays at a business can be skipped, of course, in any given month, just as a human can skip a day or even a week of eating. But if the skipping becomes routine and is not made up, the body weakens and eventually dies. Furthermore, a start-and-stop feeding policy will over time produce a less healthy organism, human or corporate, than that produced by a steady diet. As businessmen, Charlie and I relish having competitors who are unable to fund capital expenditures."

Thus, since EBITDA does not even cover the normal capex needs of the company, the master advises investors to be wary of companies and investment bankers who rely on these yardsticks to justify a leveraged deal. The master also touches upon a special type of bond known as the zero coupon bonds and goes on to add that whenever the inherent advantage that these bonds offer (deferring interest payment and not recording them till the maturity of bonds) combine with lax standards for cash flow estimation like the EBITDA, it sure is a recipe for disaster. This is what he has to say on the combination of both:

"Whenever an investment banker starts talking about EBDIT - or whenever someone creates a capital structure that does not allow all interest, both payable and accrued, to be comfortably met out of current cash flow net of ample capital expenditures - zip up your wallet. Turn the tables by suggesting that the promoter and his high-priced entourage accept zero-coupon fees, deferring their take until the zero-coupon bonds have been paid in full. See then how much enthusiasm for the deal endures."

http://www.equitymaster.com/detail.asp?date=9/20/2007&story=3

The recipe for truly high growth

The recipe for truly high growth has a handful of necessary ingredients. They are:

• A small company
• A wide market opportunity
• Meaningful macroeconomic tailwinds.  

Think, for example, of Amazon.com (Nasdaq: AMZN) when it launched in 1995. It was a tiny company, one of the first e-tailers, and it had the rising tide of the Internet -- merely the greatest development of the past 25 years -- helping it along. Now ask yourself: Do any of the companies or industry opportunities in your surveillance fit that profile at all?

Understanding Sales Growth

In general, sales growth stems from one of four areas:

 

1. Selling more goods and services

The easiest way to grow is to do whatever you're doing better than your competitors, sell more products than they do, and steal market share from them.

2. Raising prices

 

Raising prices can also be a great way for companies to boost their top lines, although it takes a strong brand or a captive market to be able to do it successfully for very long. 

 

3. Selling new goods or services

If there's not much more market share to be taken or your customers are very price-sensitive, you can expand your market by selling products that you hadn't sold before.  Investigate new markets.

 

4. Buying another company

 

The fourth source of sales growth - acquisitions - deserves special attention.  Unfortunately, the historical track record for acquisitions is mixed.  Most acquisitions fail to produce positive gains for shareholders of the acquiring firm, and one study showed that even acquisitions of small, related businesses - which you'd think would have a good chance of working out well - succeeded only about half the time.

 

 

For the investor, the goal of this type of analysis is simply to know why a company is growing. 

For example, in a beer company, you would want to know

• how much growth is coming from price increases (more expensive beer),
• how much is coming from volume increase (more beer drinkers), and
• how much is coming from market share growth (more company's brand drinkers). 

Once you're able to segment a firm's growth rate into its components, you'll have a much better handle on where that growth is likely to come from in the future - and when it may tap out.

The 4 Sources of Growth

In the long run, sales growth drives earnings growth. 

In general, sales growth stems from one of four areas:

1.  Selling more goods and services
2.  Raising prices
3.  Selling new goods or services
4.  Buying another company

Although profit growths can outpace sales growth for a while if a company is able to do an excellent job cutting costs or fiddling with the financial statements, this kind of situation simply isn't sustainable over the long haul - there's a limit to how much costs can be cut, and there are only so many financial tricks that companies can use to boost the bottom line.

Source and Quality of a company's growth

In search of high growth, we cannot just look at a series of past growth rates and assume that they will predict the future - if only investing were that easy!

It is critical to investigate the SOURCE of a company's growth rate and assess the QUALITY of the growth. 

HIGH QUALITY GROWTH that comes from selling more goods and entering new markets is more sustainable than LOW QUALITY GROWTH that's generated by cost-cutting or accounting tricks.

High growth rates are heady stuff and not very persistent over a series of years

The allure of strong growth has probably led more investors into temptation than anything else. 

High growth rates are heady stuff - a company that manages to increase its earnings at 15% for 5 years will double its profits, and who wouldn't want to do that?

Unfortunately, a slew of academic research shows that strong earnings growth is NOT VERY PERSISTENT over a series of years; in other words, a track record of high earnings growth does not necessarily lead to high earnings growth in the future. 

Why is this?

• Because the total economic pie is growing only so fast - after all, the long-run aggregate growth of corporate earnings has historically been slightly slower than the growth of the economy - strong and rapidly growing profits attract intense competition. 
• Companies that are growing fast and piling up profits soon find other companies trying to get a piece of the action for themselves.