A farmer saves the emperor’s life. The ruler says to the farmer, “I want to reward you in some way. I’m going to give you a million grains of rice—enough to feed your fam- ily for many years. You will be a wealthy man.”
The farmer says, his head bowed, “Thank you for your kindness, but I am a simple man. Perhaps you will agree to this instead—I have a checkerboard with 64 squares.
Instead of so many sacks of rice, could you do this? In the first week, give me one grain of rice for the first square of my checkerboard. The second week, give me two grains of rice for the second square. Then, each week thereafter, could you keep doubling the number of grains until all 64 squares are accounted for? I would prefer that, Your Highness.”
Perhaps you think the farmer was stupid. Perhaps not. Let’s see (see Figure 10.2).
Ahh, Grasshopper! Welcome to the law of doubling. Hopefully, you now understand why it’s next to impossible for a company to keep on doubling its revenue each year—things get big fast! The
“stupid” peasant has been granted more rice than exists in the world.
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POSITION GRAINS OFRICE
Square 1 1
Square 8 128
Square 16 32,768
Square 32 2,147,483,648
Square 48 140,737,000,000,000
Square 64 9,223,372,037,000,000,000
Figure 10.2 Doubling the Number of Grains
of Rice on Each Square of a
Checkerboard.
Rule of Thumb
So now you know what kind of growth is unreasonable. How much growth is reasonable? Well, the math required to do this from scratch is no cakewalk, so I’ve done some analysis and come up with a rough rule of thumb for you to use. If you’re a glutton for punishment, you can try the mathematics yourself. Otherwise, this should suffice.
We’re looking for unusual companies—companies growing by at least 25 percent per year. Let’s estimate for our purposes that the average rate of growth for all S&P companies is 10 percent.
This is the mean.
As you saw from Scenario 1, it’s hard for companies to main- tain rapid growth. In fact, a small decline is almost inevitable. The best companies will manage to slow their decline, the worst com- panies will slide more quickly, but on average, for growth compa- nies, the rough rule of thumb proves pretty accurate.
If you’re getting a sneaking suspicion that more math is on the horizon, you’re right. The good news is that you can trust the fol- lowing mean truth formula and plug your numbers right into it.
Figure 10.3 also shows estimates for the average decline in growth of companies at various growth rates.
Amount of decline =current year’s growth ×rate of decline Ballpark estimate of next year’s growth =
current year’s growth −amount of decline
In order to sort through all this mumbo jumbo, let’s look at a sce- nario.
R O U G H R U L E O F T H U M B
Each year most companies’ growth rates move toward the mean by about 17.5 percent of the difference, on average.
Scenario 2
A company’s revenue is growing at 40 percent per year. Looking at Figure 10.3, note that the rate of decline for a company growing between 31 and 60 percent is 15 percent. Using the formula, you calculate:
Amount of decline =current year’s growth ×rate of decline Amount of decline =40% ×15% =6%
Next year’s growth =current year’s growth −amount of decline Next year’s growth =40% −6% =34%
For the company in question, you’d expect next year’s growth to be about 34 percent. Regardless of what analysts are forecasting for this company, you should be thinking that next year’s growth will be around 34 percent.
From February 1999 to February 2000, Dell did a pretty bad job of guiding the Street. It overpromised, and the press punished Dell with headlines shouting “Dell Barely Meets the Numbers.”
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CURRENTGROWTHRATE, % DECLINE INGROWTHRATE, %
<11 0
11–20 5
21–30 10
31–60 15
61–100 20
101–200 25
200 30
Figure 10.3 Decline in Rate of Growth Based
on Current Rate of Growth.
Sun, in contrast, kept its guidance very conservative. During the same time period, it beat the numbers every quarter. Everywhere you looked, you read how great Sun was doing.
So how great wasSun doing? Almost all the investors I spoke to thought that Sun had done much better than Dell over the 12 months in question. The truth is that Dell’s revenue growth was 38 percent and Sun’s was 23 percent. Dell had grown almost 50 per- cent faster than Sun, but the headlines skewed the two companies’
trading levels. In February 2000, Dell’s P/E was around 40 and Sun’s was around 95. The company with the lower growth rate had well over twice the P/E.
Now don’t get me wrong—Sun is a fabulous company, but the numbers here just didn’t make sense. As you can see from Figure 9.5, a company growing 25 percent per year should have a P/E between 35 and 45. Sun is just such a company, and it was trading at 95! Now it is possible that Sun will grow 50 percent or more, but for the past several years its growth rate has been holding fairly steady at 20 to 25 percent. Strangely, Wall Street is likely to con- tinue to reward Sun’s stock if the company keeps beating expecta- tions and its growth holds firm or rises.
Scenario 3
Company A and Company B have perfectly matched histories. Last year they both had revenue growth rates of 40 percent; the year before, they had growth rates of 45 percent. Looking at these num- bers and applying the rule of thumb, I would expect both compa- nies to grow at about 34 percent next year. Remember, high growth rates decline toward the mean. Right now, both companies are growing 40 percent per year. The normal growth falloff for each would be 15 percent of those 40 points, or about 6 percent.
I’d start by thinking that each of these companies should grow about 34 percent next year. They’ve grown at the same rate every year since they’ve both been in business, so barring some very unusual circumstances, such as a major new product release or a key hire, that would be my expectation. But remember, analysts are predicting that Company A will grow by 50 percent and Com- pany B will drop down to 25 percent.
Let’s assume that both companies made $1 per share last year, just to keep the math easy, and that earnings grow at the same rate as revenue. Recall that Company A has a P/E of 50. If analysts are predicting 50 percent growth, that means they’re forecasting earnings of $1.50 per share for next year. And if Company B’s forecast is for only 25 percent growth, that means $1.25 per share in earnings, with a P/E of 30. When we put the rule of thumb into action and plug in the 34 percent we came up with before, it becomes clear that if we’re right, analysts have warped things.
Because of their rosy outlook, Company A is trading at $75.00 a share, while Company B is trading at $37.50. As mentioned before, I expect both companies to have similar growth for next year, and when we put our own numbers into play they’re quite at odds with industry predictions. Both companies should be trad- ing at a P/E of 40, or $54 per share. That makes Company A over- valued by more than $20.00 and Company B a steal at $37.50 (see Figure 10.4).
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W h a t Wall Street Is Saying
EPS FORECAST
LAST EXPECTED EPS NEXT STOCK
STOCK YEAR GROWTH YEAR P/E PRICE
Company A $1.00 50% $1.50 50 $75.00
Company B $1.00 25% $1.25 30 $37.50
What Mike Thinks
EPS FORECAST REALISTIC
LAST EXPECTED EPS NEXT STOCK
STOCK YEAR GROWTH YEAR P/E PRICE
Company A $1.00 35% $1.34 40 $53.60
Company B $1.00 35% $1.34 40 $53.60
Figure 10.4 Wall Street’s Analysis Versus
Mike’s Analysis.
The only weakness in this equation is that it doesn’t take incre- mental events into account. If you’re aware of some big tragedy or triumph coming down the pipe, take that 34 percent with a grain of salt.
Remember, these calculations are estimates for an average result. Almost nocompany will be average. Always expect variations from the rule, but be skeptical when those variations seem widely out of line. Whittle out the company’s reasoning for predicting unprecedented growth, and decide if you believe it.
What I’ve finally realized, after a lot of years on Wall Street, is that one company’s prognosis versus that of another often has more to do with a speech from an overly optimistic CEO than it does with anything else. No problem—the rule of thumb takes analyst optimism or pessimism out of the equation. You don’t have to take the pros’ word for anything.
S UMMING UP
● Focus your portfolio on companies that have revenue growth of at least 25 percent per year.
● As companies become more mature, high growth is harder to maintain.
● Each year, most companies’ growth rates move toward the mean (10 percent) by about 17.5 percent of the difference.
● Remember the mean truth formula:
Amount of decline =
current year’s growth ×rate of decline Ballpark estimate of next year’s growth = current year’s growth −amount of decline
● Long-term revenue growth is spurred by three major factors:
1. The company is in a marketthat’s growing rapidly.
2. The company’s market shareis growing rapidly.
3. The company creates new products or services that pro- pel it into new markets.
● Aside from rookies with the potential to be superstars, any stock you place in your portfolio should pass the three-part stockholder screen test:
1. The company has revenue of at least $100 million.
2. The company’s revenue has grown at least 25 percent each year for the past three years.
3. The company’s rate of growth decline does not exceed the rates identified as reasonable in Figure 10.3.
● Rookies should be growing by over 100 percent per year, even if they have yet to show profits.
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F
ortune magazine once called me a genius. I got a lot of phone calls that month. Journalists, portfolio managers, long-lost friends—everybody wanted to pick my brain about the next big thing.It’s pretty cool to be treated for awhile as if you’ve been handed the word of God regarding which stocks are going to hit and which are going to go under (not to say that God doesn’t have anything better to do than watch the market). But the truth is, genius or no genius, guru or no guru, noindustry expert knows for sure, in advance, how well a company’s going to do. Even the com- pany itselfdoesn’t know.
As far as I’m concerned, believing otherwise is one of the most widely held misconceptions about the stock market. It couldn’t be further from the truth. Neither analysts nor CEOs can accurately predict next year’s revenues or earnings. As a company becomes more mature, management can sometimes make a pretty good guess—but it’s only a guess. Even a Coca-Cola or a Motorola can radically miscalculate from time to time.
When you’re looking at analyst predictions on some Web site, or expert advice in a magazine, remember this: You know that phrase, “Your guess is as good as mine”? Take it to heart. Many
C h a p t e r e l e v e n