This article originally appeared in The Motley Fool on December 2, 2004.
By explicitly considering the odds of a company growing faster than expected, investors can reduce the agony of watching share price and earnings-per-share trends diverge. Here are some mainstream ideas to get started in the right direction.
Buying and holding companies with growing earnings per share (EPS) is hailed as one of the recipes for success in the stock market. While there is some truism in this, there is more to the story. Sometimes the stodgy low-expectation stocks can be growth stocks after all.
Take, for example, companies like Amgen (Nasdaq: AMGN), Cisco Systems (Nasdaq: CSCO), Clear Channel Communications (NYSE: CCU), Coca-Cola (NYSE: KO), General Electric (NYSE: GE), and Home Depot (NYSE: HD).
These companies have increased their EPS substantially over the past few years. This year, Cisco and Clear Channel are expected to deliver EPS numbers up about 150% over their 2000 results. Yet, after adjusting for splits, shares of these companies trade at levels lower than they did several years ago.
The following chart illustrates exactly how EPS has increased for these companies.
|Company||Stock Peak||EPS in FY in Previous Column||Peak Price||Current FY Est. EPS||Current Price||EPS Change||Price Change|
|Cisco||2000||0.36||82.00||0.90||19.23||Up 150%||Down 77%|
|Clear Channel||2000||0.57||95.50||1.42||34.76||Up 149%||Down 64%|
|Qualcomm||2000||0.43||100.00||1.03||41.40||Up 140%||Down 59%|
|Coca Cola||1998||1.42||88.93||2.00||39.86||Up 41%||Down 55%|
|Gen. Electric||2000||1.27||60.50||1.61||35.44||Up 27%||Down 41%|
|Home Depot||2001||1.10||70.00||2.26||43.37||Up 105%||Down 38%|
|Amgen||2000||1.05||80.43||2.43||60.21||Up 131%||Down 25%|
What went wrong? While increasing EPS is good, what is more important is the comparison between expected and actual growth rate. These companies did not increase EPS at rates they were expected to some years ago. Overestimating business prospects is a common nemesis of growth stock investors. A perfect example is the dot-com era, when investors and corporations overestimated growth prospects.
The omnipotent growth rate
Irrespective of whether a stock is classified growth or value, it is the present value of the company’s future free cash flows that determines how much the underlying business is worth. Obviously, a projection of rapidly rising free cash flows significantly increases the value of the company, i.e., its stock price. Therefore, growth rate becomes a key driver in how much a business is worth.
Implicit in every stock price is an estimate of the company’s future growth rate. Finding companies where the actual growth rate will turn out to be higher than the forecasted or implied growth rate increases the odds of getting rewarded as an investor.
To take a stab at identifying companies likely to exceed the expected growth rate, the first step is to figure out the expected growth rate. Constructing a discounted cash flow model can come in handy since, assuming your projections are correct, the implied growth rate can be backed out. If the DCF minutia is daunting, you can use the long-term EPS growth rate, projected by analysts, as a surrogate.
Then comes the real work: assessing whether the company is actually likely to exceed the implied growth rate. Understanding the company’s drivers of sustainable growth — new products, proprietary technology, demographic changes, etc. — is a starting point. The more important part is to focus on how these drivers may change in the future and how such changes may impact the growth rate.
The P/E/growth, or PEG, ratio is often used to ensure growth is purchased at a reasonable price. Although this tool offers a short cut, it does come with baggage. The push toward selecting stocks with lower PEG ratios penalizes companies with low growth expectations — a fertile ground of underappreciated stocks. Likewise, higher quality companies that deserve a higher P/E multiple may also get cut out.
Seeking growth in value
Shares of companies with high expectations are more at risk for growth rates not panning out as high as expected. One way to reduce the risk of overpaying for growth is to snoop around for companies with low expectations.
While the approach is unlikely to yield a moon rocket, it can lead to some stodgy growth picks. “Stodgy growth” may seem like an oxymoron, but it’s through such a strange combination that the potential for unique profit is created. With the market having come around close to a full circle from the go-go growth days of the late ’90s, the task of finding such growth stocks has become easier.
For a start, take a look at Home Depot, Nextel Communications (Nasdaq: NXTL), Time Warner (NYSE: TWX), and McDonald’s (NYSE: MCD). Given that investors do not appear to be in love with these stocks, they sport modest, yet meaningful, growth rate projections with possibility for upside. In my mind, favorable resolution on factors bugging each of these stocks appears likely. And savvy value managers have loaded up on some of these stocks.
|Company||5-Year Estimated Growth Rate||PEG Ratio|
In the battle between Lowe’s (NYSE: LOW) and Home Depot, investors have seemed fixated with Lowe’s as it continues to attack Home Depot’s store base. Meanwhile, Home Depot is executing quite well under the leadership of Bob Nardelli, with same-store sales ticking up nicely. Home Depot recently upped its 2004 EPS growth guidance from 14%-17% to 19%-20%. Analysts have followed suit and bumped up predicted EPS growth to a 20.2% clip this year. Their expectation for growth over the next five years remains a more modest 13.0% annually, which in turn leaves the company with the possibility of exceeding expectations.
Shares of Nextel, the top holding (as of 11/26/04) of Bill Miller’s Legg Mason Value Trust (FUND: LMVTX), have been tethered back due to concerns over the company cost-effectively swapping wireless spectrum licenses with safety agencies. A few months ago, Verizon Communications (NYSE: VZ) vehemently opposed Nextel’s spectrum swap plan, which was approved by the Federal Communications Commission in July. The gripe was that the spectrum Nextel was receiving was worth substantially more than the value estimated by the FCC. Earlier this month, though, Nextel and Verizon reached an amicable settlement. The next frontier for wireless carriers is data services. And, Nextel’s capital expenditure plans suggest that the company does not want to be left behind. The 12.9% 5-year growth rate expected by analysts for the nation’s largest pure-play wireless carrier may well prove to have been conservative.
Remember Time Warner? This company has come full circle after agreeing to merge with AOL, forming AOL-Time Warner, and then dropping AOL from its name. Time Warner investors have been less than amused with the lawsuits and investigations surrounding the company, not to mention the shrinking subscriber base of the AOL narrowband business.
Time Warner appears to be making headway on at least one of the major issues: The company is reported to be working out a $750 million settlement with the Securities and Exchange Commission. Time Warner is, however, a big free cash flow machine — close to $4 billion big. Whether the present management can hit some home runs with this cash to trounce the expected growth rate is the $64,000 question. Time Warner wins the Motley Fool Stock Advisor’s approval.
The stellar same-store numbers posted by the U.S. operations of McDonald’s have not whetted investors’ appetites. The Mad Cow disease scare, obesity issues, and management health have drawn attention instead. The recent appointment of James Skinner as CEO is likely to bring stability. The hamburger chain has the potential to exceed the analyst-expected 8.1% five-year growth rate if it can replicate its U.S. successes in Europe — and help “degrease” waistlines. Bill Nygren has found McDonald’s compelling enough to make it Oakmark Fund’s (FUND: OAKMX) second-largest holding as of September 30, 2004.
There are more stocks in today’s market than just Home Depot, Nextel, Time Warner, and McDonald’s. So, as part of your holiday shopping plans, seek bargains like you would for a value stock, while keeping an eye out for growth. If you do, you will likely find stocks with the prospects for above-average EPS growth trading with the attributes of their value brethren. In due course, they may prove to be a good deal.