— Warren Buffett
When Warren Buffett purchased See's Candy in 1972, it represented a departure from his prior purchases. For the first time, Buffett purchased a business at a large premium to its tangible assets. The idea that the value of certain intangibles which a business possesses could far outweigh the value of their tangible assets came as a revelation to Buffett. This revelation would effect his concept of value investing for the rest of his life.
It could be said that the new Buffett strategy was a marriage of growth and value. He recognized that returns on invested capital and how these returns were deployed was just as important as the price one paid for a business. If the management squandered the cash the business generated, the business would flounder. On the other hand, if they reinvested the profits efficiently, the value of the business would increase immensely, generating far greater free cash as time passed. Thus Buffett's focus turned from the traditional Graham/Schloss approach of asset evaluation to one of business evaluation.
Joel Greenblatt created "Magic Formula" investing based upon the combination of two simple concepts; specifically, high earnings yields and high returns on invested capital were instrumental in identifying bargain businesses. In essence, he had created a stock screen which identified the two most important concepts which Buffett had utilized in creating an earnings-driven approach to value investing. In simple words, one should attempt to buy great businesses at fair prices. The earnings yield represented the fair price aspect, while the efficient redeployment of these profits resulting in growth, defined the quality aspect of the business.
Long before Greenblatt began writing his series of books on the Magic Formula, Peter Lynch formed his own concept of how to unite the divergent concepts of growth and value. He called his formula the PEG ratio; the ratio has taken a permanent place in the lexicon of value investing.
A PEG ratio is defined as the price to earnings ratio/earnings growth rate. If a stock has a PE ratio of 15 times earnings and an earnings growth rate of 15%, the ratio would equal one; Lynch would consider such a stock to be fairly valued. The lower the number the better. Any company with a growth rate significantly higher than their PE ratio is an potential multibagger, so long as the growth persists.
The idea is that outstanding businesses which experience rapid growth should be priced at higher multiples than mature slow-growing businesses. The formula seems to work best for smaller companies which are generally not cyclical in nature. Retailers are logical candidates for PEG ratios. These are the types of businesses which Lynch liked to visit and observe during visits to shopping malls.
Let's examine the trailing results of Panera (PNRA) in the last decade. Panera sells bagels, pastries, coffee, soups and sandwiches throughout the United States. The business immediately impressed me when they first moved into our city about a decade ago. The large divergence of the customer base, the quality of the food and drink, in addition to the continual flow of customers were the sources of my favorable impressions. Alas, I never purchased a share of Panera as I deemed the business to be too expensive. Was the business really expensive in terms of a PEG ratio? Lets take a look at their trailing ten year results:
If we examine the five-year fiscal earnings from Dec of 2001 to December of 2005, Panera experienced a growth rate of just under 37% annualized. Earnings moved from $0.46 per share on December 31, 2001 to $1.65 per share by December 31, 2005 . What was the average PE ratio for Panera during that period? The answer is about 36 times earnings.
Incredibly, the fair value of Panera as defined by a PEG value of 1.0 was verified by the market over the five-year period. Look at the resulting chart, which owners must have viewed as a Mona Lisa: http://moneycentral.msn.com/investor/charts/chartdl.aspx?symbol=US:PNRA&&CP=0&PT=10. The split adjusted share price moved from about $26 per share on December 31, 2001 to $66 per share by December 31, 2005.
The Problem with High PE Ratio PEG Stocks
It seems so long as Panera continued to grow earnings at a 37% clip, the bloated PE ratio was justified. The problem began during the fiscal year of 2006 when the earnings growth slowed dramatically. When the growth slowed, the high PE multiple was not sustainable and the stock price crashed. High PE stocks which are fairly priced in terms of PEG ratios have no margin of safety when earnings growth slows or ceases. If you reconsult the chart you will see that two years later the stock had lost nearly half of its price per share.
Panera was still an extremely profitable business, but the market no longer considered that the company merited such a lofty multiple. For the next several years the stock traded with a PE ratio of closer to 20 times earnings.
Fortunately for buy-and-hold Panera investors, the company has since resumed its prior growth rate and the stock has soared well past its former heights. Once again it boasts a lofty PE ratio and high growth rate, at least for the time being.
The larger a company grows, the more difficult it is to grow earnings at a 35%-plus clip on a year-over-year basis. Panera now has a market cap of nearly $4 billion. I find it highly unlikely that they can sustain the amount of growth necessary to justify their current PE ratio of nearly 35 times trailing earnings. Investors need to bear in mind what happened the last time that Panera was unable to maintain a fair value peg ratio of around 1.0. Even great companies like Panera can become significantly overvalued.