Are Growth Stocks Experiencing Déjà Vu All Over Again? Don’t be Fooled This Time!

Especially in today’s fast-changing market, it doesn’t matter whether you are a value investor, momentum investor, research analyst or manager of a long/short portfolio. Having the ability to objectively validate, contextualize and compare the expectations and risk that drive a stock’s price are crucial for maintaining consistently strong investment performance. Click here for a free trial of the Market Topographer^TM web-based stock analysis platform and see for yourself. 

During bull runs in the stock market, investors routinely get away with taking short cuts when it comes to fundamental analysis. Vague “rules of thumb” such as P/E to growth, for example, become popular for justifying the price of growth stocks. For although a miss hit may result in under-performance of a particular stock investment, there is a lower likelihood of a portfolio drawdown as most stocks will tend to rise with the tide. Over the past ten months, we have experienced the greatest short term bull run since the 1930s and most economists point to the end of the longest recession in recent history having occurred a few months back. But an end to the recession does not necessarily suggest we will experience the robust “v-shape” recovery we all hope for.

This sets up a more difficult environment for investors for next year, particularly in regard to high profiled growth stocks that have regained relatively lofty valuation levels. As of December 24, 2009, Starbucks (SBUX) was trading at a P/E of 23x 2010 EPS vs. a market average of 17x. But is the market behaving rationally? Can the longer term expectations of future cash flow growth priced into Starbucks be justified given its size and level of maturity, or is its price being driven by unfounded momentum that always seems to appear when market optimism peaks?

Determining if Growth Expectations Priced into a Stock are Reasonable

In the Based on Experience module of OCE Interactive’s web-based Market Topographer^TM stock analysis platform, investors can objectively evaluate whether the risk adjusted expectations currently priced into a stock are reasonable. Market Topographer enables this by demonstrating the range of justified prices for a particular stock in today’s marketplace given:

(i) Wall Street’s cash flow and earnings expectations for that stock for the next two years; 

(ii) the stock’s risk profile as defined by 12 risk assessment characteristics;

(iii) current market conditions including how the market is willing to reward or penalize those 12 defining characteristics; and 

(iv) the assumption that the market is appraising the likelihood that the company would achieve long term cash flow growth expectations for a 10 year period beyond Wall Street’s two year explicit forecast, that matched the actual achievements of relevant companies over the past 40 years. 

In other words, Market Topographer factors in Wall Street’s near term expectations for the company as well as its existing risk profile and current market conditions, but it then recalculates a series of justified prices for the company by replacing the long term cash flow growth expectations it determines that the market currently seems to be pricing into the stock with the actual growth achievements of relevant companies historically. No arbitrary terminal value assumption is needed. It presents the results in a histogram and accompanying table summarizing the distribution of implied prices including the average and median, as well as details regarding each precedent company. The user can fine-tune the analysis by checking the box next to the specific matches deemed to be the best benchmarks. 

Although every company and every situation are unique, investors can learn a lot about the future prospects of a company by studying the past achievements of other companies over time. This is especially true in regard to expected cash flow growth given the “physics” of finance which almost always dictates that as a company grows larger, its earnings growth slows and its dividend payout ratio increases. That is why Market Topographer’s primary default criteria for selecting historical precedent companies is to identify those that had a similar size earnings base, on an inflation adjusted basis, as the subject company is currently expected to achieve.

The Starbucks Example – Then and Now 

Roughly three years ago in November 2006, Starbucks stock price hit its all-time high of $40.01. Compared to most other stocks at the time, this valuation seemed high. But could this price be justified or in other words could the expected long term growth expectations the market was paying for be supported? With Market Topographer, a user could have evaluated this objectively by drawing from the precedents set by the historical growth achievements of similar companies historically. Market Topographer would have displayed the resulting implied (justified) prices for Starbucks based on the identified historical precedents in a histogram. By seeing how far into the right tail of the histogram Starbucks’ then actual price fell, it would have been blatantly obvious how over-valued it was—roughly 77%. In fact, the average implied price due to historical precedents would have suggested a fair value for Starbucks was around $22.55. One month later, the price of Starbucks began a two year decent bringing its price down to around $20.

More recently, Starbucks’ price has once again rallied tremendously closing at $23.66 on December 24, 2009, up 229% from a low of $7.17 in November 2008. Market Topographer calculates an average implied (justified) price for Starbucks (based on roughly 140 historical precedent matches) equal to $19.37 and with just a little refinement to the list of matches, you can get to $22.41 (only 5% below its then current price). Although the expectations baked into Starbucks’ price may once again be a bit aggressive, Market Topographer demonstrates that they do not appear to be over the top when compared with the historical fundamental achievements of other companies, and therefore could certainly be achievable. That being said, if the stock market were to pull back some time in the New Year, it wouldn’t be surprising to see a greater than average correction in the price of Starbucks given the way the market is currently valuing companies having a similar profile. 

OCE Interactive developed the Market Topographer platform to provide investors and advisors with (i) an objective means of evaluating the reasonableness of expectations and risk priced into stocks, (ii) the ability to anchor a stock’s valuation with historical precedents and (iii) unprecedented ability to compare the risk profiles and valuations of almost any publicly traded U.S. stocks currently, historically and across time.

Invitation to Try Market Topographer for Free

We invite you to give Market Topographer a try for free. Simply click here or go to www.markettopographer.com. There are no obligations and no credit cards needed. Just register by entering your name, email address and company name on our online registration form. Then choose a password, press the ‘Launch’ button and you are off to the races. After you register, you can continue to use Market Topographer during our trial period by simply returning to www.markettopographer.com and entering your email address and password. To the extent you have questions as to how to most effectively use the Market Topographer platform or would like to arrange for a demonstration either in person or via webex, please contact us at contact@oceinteractive.com. We look forward to hearing from you. 

--Jonathan Greenberg, CFA, president, CEO and chief software designer of OCE Interactive, has spent nearly 20 years on Wall Street. Prior to co-founding the predecessor of OCE Interactive in 2003, Greenberg spent the bulk of his career as an investment banker at Salomon Brothers and Lehman Brothers.

About OCE Interactive

OCE Interactive is the developer of Market Topographer™ (www.markettopographer.com), a new platform for benchmarking and valuation analysis of U.S. stocks. Market Topographer combines fundamental and behavioral analysis to help investors and advisors evaluate, in an objective and market-consistent way, whether a stock is reasonably priced, with a particularly strong focus on assessments of the company’s relative risk profile and whether the expectations embedded in its stock price are achievable. OCE was founded in 2003 by a team of former bulge-bracket investment bankers and Wall Street executives, who spent more than six years developing the Market Topographer platform. Currently, the company has six patents pending on its technology and an extensive pipeline of additional tools for equity valuation and mergers and acquisitions practitioners. The company is based in New York.