I spend the vast majority of my time hunting down securities I believe are significantly undervalued and investigating those in great detail I believe have considerable upside potential. However, it's also a valuable exercise to spend some time on the opposite end of the spectrum and analyze what I find to be unappealing or speculative investments that offer horrible risk/reward tradeoffs.
Fast-growing companies are prime real estate for uncovering investments that can head south in a big hurry. Growth in itself is an extremely important metric in finding appealing investments. As such, it is the valuation that can end up causing big headaches for investors in rapidly-growing firms.
Momentum is another issue. A significant demographic of investors includes individuals and institutions that trade with black-box-type algorithm models, screening for and investing in companies experiencing acceleration in sales and earnings, or have made a habit of beating analyst expectations for a number of quarters in a row. The problem is, this class heads for the hills at the first sign of trouble.
VMware (NYSE:VMW) meets many of the criteria that can make for a bad investment. For starters, it operates in the very rapidly growing market for virtualization software that allows for cloud computing. It serves the burgeoning market for software as a service, or Saas, for short. It's about as hot as any sub-industry in tech and is expected to remain so for the foreseeable future.
VMware is growing like gangbusters right now. It recently announced third quarter results that saw sales jump +46% to $714 million and recurring earnings catapult +63% higher to $0.39 per share. Earnings beat analyst projections, and have either met or beat consensus targets for at least seven quarters in a row now. That is music to the ears of the momentum crowd -- for now that is.
As for the valuation, you guessed it: Analysts currently project full-year earnings of $1.39 per share. The stock price, which is hovering in excess of $70 per share, means the shares carry a forward P/E of almost 53. That is nose-bleed territory, reminiscent of the dot-com days when many leading tech companies were trading at very lofty multiples.
The company is expected to grow sales close to +40% for the full year. Projected free cash flow generation is decent, as VMware is expected to report more than $1 billion, or more than $2.56 in free cash flow for the year. However, that's still an excessive multiple of almost 29.
Action to Take ---> What will likely trip up future gains for VMware's stock is the very high growth that the company must post going forward. The higher the multiples of earnings and cash flow, the higher a firm must grow to justify where the stock is trading.
Companies are valued by discounting their expected future cash flow back to the present at a certain discount rate. The higher the stock price, the higher growth has to be to justify the price. It's nice to find a company that is posting impressive growth in this market, but you should stay away from those that have been bid up excessively. Growth at any price is not a valid strategy in this market.
By my estimations, VMware must grow its cash flow by more than +30% each year for the next five years. If it does that, then the stock is fairly valued. In total, this means cash flow must more than triple to more than $9.50 by 2016. To do this, sales must grow at a similar clip.
It's definitely achievable, but I see a higher likelihood that VMware falls short of these aggressive expectations, which means its current shareholder base will exit the stock just as rapidly as it entered. Again, the company's operations are growing impressively and is appealing in this regard. But this represents a case of a good company -- but a bad stock. The valuation for VMware is just too high. In fact, it's about as high as I can find in the market, which makes this one of the most speculative investments out there today.
-- Ryan Fuhrmann
A graduate of the University of Wisconsin and the University of Texas, Ryan Fuhrmann, CFA, adheres to a value-based investing viewpoint that successful companies... Read more...
This article originally appeared on StreetAuthority