Friday, April 09, 2010

Value of Growth

"A cynic is a man who knows
the price of everything
and the value of nothing.”

Oscar Wilde


As the Dow Jones approaches the 11,0000 level a realistic look at growth and value makes sense. In the first quarter 2010, companies in the S&P 500 reported an earnings growth in the high 30s. The earnings growth rate for the S&P 600 composed of companies under $2 billion in market cap turned out growth in the low 30s. Granted the comparisons are off exceptionally low bases as the year-ago period was a time of economic darkness for most U.S. companies. The realization of this is probably why the S&P 500 Index is trading at just 22.0 times trailing earnings - well below the level that would equate the PE ratio with the growth rate for this bell weather group.

The growth rate has been a popular gauge for determining a fair earnings multiple. A PE below the growth rate leads to a ratio below 1.0 and is considered a bargain. In our Crystal Equity Research publications we use this line of reasoning frequently, tweaking the formula to include dividends and risk. We call it PERGY - Price/Earnings Times Risk to Growth Plus Yield. Our argument is that not all companies are created equal and the risk measurement in the form of beta helps put the stock into the right perspective. Adding dividend yield to the formula acknowledges that companies returns value to shareholders through both stock price appreciation and dividends.

The PEG or PERGY approach comes in very handy in those situations when comparable stocks are few, but is useless in early stage companies that have yet to reach profitability. The valuation of foreign operations with U.S. domiciles and U.S. listed securities is also well served with this approach since U.S. operations with U.S. listings are not directly comparable. Nor are peers and competitors with listing in home markets. The formula is only as good as the inputs. Which earnings growth rate should be used? The growth rate over the last year or over a period of years? The forward earnings growth? Furthermore, how reliable is the beta calculation?

We use the forward earnings growth rate over the next two years since equity markets are forward looking. For beta we use an average of three or four sources for beta calculations, since the degree of variance in beta calculations is surprisingly significant.

There are times we are prepared to pay more than the growth rate for a stock. Consider a company like Phase Forward (PFWD: Nasdaq) that is the dominant player its market and appears to have a formula that will allow it to keep its “king of the mountain” status in the extended term (three to five years). There are also times we view even a PEG ratio below 1.0 too generous a valuation. For example, Telestone Technologies (TSTC: Nasdaq), which has a beta of 3.10 and a trailing earnings growth rate of 60% and a trailing earnings ratio of 17.2 times. This produces a PERGY of 0.86. Yet we regard TSTC as near full valuation given the high population of competitors in the wireless communications sector and Telestone’s relatively short experience in markets outside its homeland of China. Likewise we are a bit skeptical of US Ecology’s PERGY ratio of 1.02. Our skepticism is fed by a suspicious forward growth rate of 20% calculated from the consensus estimates. Our own estimates suggest the future sales will be flat at best through the next year.

The counter argument is that beta already captures competitive factors since these are embedded in historic trading. An investor must be an enthusiastic adherent to the perfect form of the efficient market hypothesis to make this argument with a straight face. We could be influenced one way or the other and so take a look at one more factor before swallowing or dismissing beta. In the small cap sector, we view beta calculations as less than reliable if trading volumes are shallow. Healthy trading action and measurable institutional ownership lend credibility to the quality of the beta calculation.


Neither the author of the Small Cap Strategist web log, Crystal Equity Research nor its affiliates have a beneficial interest in the companies mentioned herein. Crystal Equity Research has published ratings on ECOL, PFWD and TSTC.

No comments: