One of the common themes among the very best performing stocks is that they are attached to a high price-to-earnings ratio. It makes sense that the fastest growing companies deserve a higher multiple than the average stock. You’ll notice in the table below that nine out of ten of the strongest stocks over the past decade traded at a higher average multiple than the S&P 500.
One of the common things people say when talking about these high priced stocks is that the future growth of the company is already priced into the stock. This line of thinking has been around for a long time. In 1958, Philip Fisher takes this view to task in his “lists of don’ts” in Common Stocks and Uncommon Profits.
4. Don’t assume that the high price at which a stock may be selling in relation to earnings is necessarily an indication that further growth in those earnings has largely been already discounted in the price.
There is a costly error in investment reasoning that is common enough to make it worthy of special mention. To explain it, let us take a fictitious company. We might call it the XYZ Corporation. XYZ has qualified magnificently for years in regard to our fifteen points. For three decades, there has been constant growth in both sales and profits, and also there have been enough new products under development to furnish strong indication of comparable growth in the period ahead. The excellence of the company is generally appreciated throughout the financial community. Consequently for years XYZ stock has sold from twenty to thirty times current earnings. This is nearly twice as much for each dollar earned as the sales price of the average stock that has made up, say, the Dow Jones Industrial Averages.
Today this stock is selling at just twice the price-earnings ratio of the Dow Jones averages. This means that its market price is twice as high in relation to each dollar it is earning as is the average of the stocks comprising the Dow Jones averages in relation to each dollar they are earning. The XYZ management has just issued a forecast indicating it expects to double earnings in the next five years. On the basis of the evidence at hand, the forecast looks valid.
Whereupon a surprising number of investors jump to false conclusions. They say that since XYZ is selling twice as high as stocks in general, and since it will take five years for XYZ’s earnings to double, the present price of XYZ stock is discounting future earnings ahead. They are sure the stock is overpriced.
No one can argue that a stock discounting its earnings five years ahead is likely to be overpriced. The fallacy in their reasoning lies in the assumption that five years form now XYZ will be selling on the same price-earnings ratio as will the Dow Jones stock which they compare it. For thirty years this stock, because of all those factors which make it an outstanding company, has been selling at twice the price-earnings ratio of these other stocks. Its record has been rewarding to those who have placed their faith in it. If the same policies are continued, five years from now its management will bring out still another group of new products that in the ensuing decade will swell earnings in the same way that new products are increasing earnings now and others did five, ten, fifteen, and twenty years ago. If this happens, why shouldn’t this stock sell five years from now for twice the price-earnings ratio of these more ordinary stocks just as it is doing now an has done for many years past? If it does, and if the price-earnings ratio of all stocks remain about the same, XYZ’s doubling of earnings five years from now will also cause its price to have doubled in the market over this five-year period. On this basis, this stock, selling at its normal price-earnings ratio, cannot be said to be discounting future earnings at all!
Obvious, isn’t it? Well, look around you and see how many supposedly sophisticated investors get themselves crossed up on this matter of what price-earnings ratio to use in considering how far ahead a stock is actually discounting future growth. This is particularly true if a change has been taking place in the background of the company being studied. Let us now consider the ABC Company instead of the XYZ Corporation. The two companies are almost exactly alike except that the ABC Company is much younger. Only in the last two years has its fundamental excellence been appreciated by the financial community to the point that its shares, too, are now selling at twice the price-earnings ratio of the average Dow Jones stock. It seems almost impossible for many investors to realize, in the case of a stock that in the past has not sold at a comparably high price-earnings ratio, that the price-earnings ratio at which it is now selling may be a reflection of its intrinsic quality and not an unreasonable discounting of further growth.
What is important here is thoroughly understanding the nature of the company, with particular reference to what it may be expected to do some years from now. If the earning spurt that lies ahead is a one-time matter, and the nature of the company is not such that comparable new source of earning growth will be developed when the present one is fully exploited, that is quite a different situation. Then the high price-earnings ratio does discount future earnings. This is because, when the present spurt is over, the stock will settle back to the same selling price in relation to its earnings as run-of-the-mill shares. However, if the company is deliberately and consistently developing new sources of earning power, and if the industry is one promising to afford equal growth spurts in the future, the price-earnings ratio five or ten years in the future is rather sure to be as much above that of the average stock as it is today. Stocks of this type will frequently be found to be discounting the future much less than many investors believe. This is why some of the stocks that at first glance appear highest priced may, upon analysis, be the biggest bargains.
Here comes the counter point, for every expensive stock that delivers outsized returns, many more of these companies do in fact price in future growth and then some. Patrick O’Shaughnessy notes that: “The best performing glamour stocks beat all stocks by an average of 115% over the coming year. Talk about winning the lottery. But here is the problem: the median glamour stocks lost to the market by -11%, on average and the worst glamour stocks lost by 75%.”
Take DDD as a recent example, which was fetching over 3,000 time earnings last March. Over the previous twenty months, this stock has lost 91% of its value.
It’s one thing to read and enjoy these do and don’t lists. However, putting these ideas into practice and executing them is extremely difficult. Identifying which stocks will continue to grow versus those that are just a flash in the pan is easier said than done.