Current Year EPS/Prior Year EPS
Yes. That’s basically a growth rate. But I’ll show you why you want to put it in these terms.
Let’s start with Walgreens (WAG).
Walgreen's earnings per share (for the last nine years — that is, starting 10 years ago) looks like this:
$1.15/$0.99 = 1.16
$1.33/$1.15 = 1.16
$1.54/$1.33 = 1.16
$1.74/$1.54 = 1.13
$2.05/$1.74 = 1.18
$2.18/$2.05 = 1.06
$2.02/$2.18 = 0.93
$2.15/$2.02 = 1.06
$3.00/$2.15 = 1.40
Minimum = 0.93
Maximum = 1.40
Median = 1.16
If you want to get extremely fancy you can look at the standard deviation — 0.12 — and the mean 1.14 and then go ahead and divide the standard deviation by the mean. The result is 11%.
Standard Deviation (0.12) / Mean (1.14) = Variation (11%)
That's a measure of the variation of the growth you are seeing in Walgreen's earnings per share. For the vast majority of stocks taking the last ten ratios of current year's EPS over prior year's EPS and then dividing the standard deviation by the mean will result in a much, much higher number than 11%.
It’s not necessary to calculate variation. It just confirms in numbers what you can see with your own eyes.
Walgreen has very steady EPS growth. Also, note that the increase from $2.15 to $3 is unusual and can't be maintained. Any growth rate much above 20% should be suspect as very few companies can maintain growth rates over 25% for long periods of time.
You'll generally find that a company growing 30% a year is not necessarily a better long-term investment than a company growing 20% a year because the reliability of 30% growers as they age is usually significantly worse than the reliability of 20% growers as they age.
Now let's do the same exercise for Apple (AAPL):
$0.10/$0.09 = 1.11
$0.36/$0.10 = 3.60
$1.61/$0.36 = 4.47
$2.33/$1.61 = 1.45
$4.02/$2.33 = 1.73
$5.46/$4.02 = 1.36
$9.19/$5.46 = 1.68
$15.34/$9.19 = 1.67
$27.96/$15.34 = 1.82
Standard Deviation (1.07) / Mean (2.10) = Variation (51%)
Notice the number of years in which Apple has had incredibly high growth. Then there's the huge range between the minimum and maximum ratios of current EPS to last year's EPS. The variation is high. And the ratios don't top out at a high point for the economy and bottom out at a low point. That suggests the variation in Apple's growth rate is more likely company specific than macroeconomic.
Whereas Walgreens' growth history shows the expected pattern of having its worst EPS growth (a 7% decline in earnings) occur in an economic downturn and its best EPS growth (a 40% jump) in an economic recovery. Also, half of Walgreens' years show the company posting a double-digit EPS growth rate in the very sustainable range of 13% to 18%.
Apple had only a single year of growth (at an 11% rate) that could be considered sustainable. The next closest rate of sustainable double-digit growth was 36% which is way too high an EPS growth rate to be sustained.
None of this is to say that Apple’s earnings, sales, etc. will fall off a cliff. I’m just saying that the company’s long-term growth potential is a lot less impressive than people think.
Here’s what I’m really saying. Say I have two companies in front of me. One is Apple. The other is a company with the same earnings variability as Walgreen but 20% a year growth over the last 10 years and a market cap of $600 million.
Which company do I think will grow at a faster rate?
Apple — which grew earnings per share at 78% a year over the last 10 years — or a smaller, steadier growing company that compounded EPS at just 20% a year?
I’d give a slight edge to the smaller, steadier growing company. Huge size and highly variable past growth are not good omens for future growth.
At well over $100 billion in sales Apple is actually even bigger than Walgreen. Big size is a big anchor. If you were looking for the best candidates for great growth over the next 10 to 30 years — a real buy and hold investment — you’d start with companies under $1 billion in sales, market cap, etc., that had very little variation in their sales growth over the last 10 years and grew right around 20% a year (tops).
The list might include companies like:
· Bio-Reference Labs (BRLI)
· World Acceptance (WRLD)
· Peet’s Coffee & Teas (PEET)
Am I suggesting buying those stocks?
Not exactly. There are three issues to look into:
1. Industry Bubble
2. Management Integrity
It may sound odd for a value investor to list price last, but it’s by far the last important issue to consider with consistently fast growing, reasonably sized — that is, not Apple’s size — companies.
Ten years sounds like a long time. But it’s not that long in certain cycles. Credit can expand for 10 years and then fall apart. Government spending priorities can favor a certain industry for a decade or more — then reverse. And certain societal trends that are a bit on the faddish side can last for longer than 10 years.
What you want to avoid here is betting on the continuation of some kind of mania. Every company that grows 20% or so a year for 10 years is likely going to have had a wind at their back. You would prefer that wind is not a national delusion, fraudulent industry practices, etc.
Uh, I’ll just say that’s a concern with the names I mentioned there. Two of those companies are in industries with ethical issues (Bio-Reference Labs and World Acceptance). There is government interference (in very different ways) in both industries. I’m not saying that either company is now or has ever done anything wrong. But I’m saying certain competitors definitely have.
And perhaps even more importantly those two companies – Bio Reference Labs and World Acceptance – are in industries that have an especially high degree of let’s call it a temptation toward immorality. Basically, their interests, their customers’ interests, their salespeople’s interests, and the interests of other “influencers” in their market space is complex and prone to ethical challenges. In each case, it is in somebody’s interest to recommend a course of action that is probably self-destructive either to an individual or to the public at large.
My concern here is not moral. A cigarette company is clearly killing its customers. But you know that going in. And more importantly, the people who are being killed know that. And even more importantly, the general public knows that.
In some other industries — payday loans, lab tests, higher education, etc. — the public probably doesn’t realize the extent to which the costs these industries have for their customers and for society generally compare to the benefits.
The idea here is basically for you to avoid buying a subprime lender that has been growing nicely up through the 2000s — right at the worst moment. You want to avoid bubbles of that kind. Again, it’s not an ethical issue. I don’t really care if you approve of what the company is doing. But you should understand the incentives that exist in the industry.
We have the same sort of issue with management integrity. And really company integrity generally. What is the culture? Is the CEO open, honest, direct, etc.? Obviously the CEO will be a growth chaser if the company has been growing close to 20% a year for 10 years. He probably won’t be interested in returning cash to shareholders — that’s usually fine if the company is growing around 20% a year for a long time. In fact, the money is probably better off in his hands.
But how likely is he to smooth earnings? How likely is he to overpay for an acquisition? Most importantly, how destructive will his behavior be toward shareholder interests when growth slows, and/or Wall Street turns on the company.
Even if growth doesn’t slow Wall Street will find a reason to dislike the stock for a while. What would the CEO do in that situation? You generally want to avoid someone who will totally change the company, disrupt everything he’s built up to that point, issue a lot of shares in some pricey acquisitions just so he dip a toe into the next big thing – and so on. It’s not necessarily a plus to have a CEO who wants to please the street.
Finally, there’s the issue of price. What is the right price to pay for a consistent, fast growing company?
If your holding period is forever and the company really does grow and grow and grow at a very nice pace – the answer (value investors avert your ears) is that almost no price is too high. And almost any price will turn out to be a bargain in hindsight.
The reason to not pay too high a price is humility. You are probably humble enough to think you might be wrong about the company’s future growth. In which case, the closer you can get to paying the going price for a “good enough” business when you buy a truly wonderful business — the smaller your loss will be when the company turns out not to be as wonderful as you thought.
Ideally, you shouldn’t pay more than today’s median P/E ratio for stocks. Let’s say that’s 14 right now. And I’m not talking the “forward” P/E here. I’m talking today’s price divided by last year’s earnings.
Do the three stocks I mentioned pass that test?
No. Only World Acceptance (WRLD) does.
In fact, we have a good example here of a high, low and medium price for a true growth stock.
At 11 times last year’s earnings World Acceptance is surprisingly cheap for a growth stock. If you know the industry the company’s in — and the times we live in — it’s not so surprising. One problem here is the company’s market cap — it’s $970 million. And that’s on a discount price. At a normal valuation for a public company in 2012, World Acceptance would have a market cap of more than $1.3 billion. Revenue was under $500 million last year. Overall, this is not a small company. Smaller would be better here. You’d have been better off buying WRLD 10 or 15 years ago than buying it today.
Anyway, 11 times earnings is obviously an acceptable price to pay for a growing business. If you like World Acceptance — and you’ve answered the other two questions (Industry Bubble? and Management Integrity?) to your satisfaction — go ahead and buy World Acceptance.
What about BRLI?
Bio-Reference Labs (BRLI) trades for more than 17 times earnings. Overall, a bit high by both current market standards and historical average prices paid for a run of the mill company. So, is BRLI worth the premium? From a mathematical perspective, sure. The issue is how safe the investment is if it turns out the company is not a fast grower but merely another plodding Quest (DGX) or Lab Corp (LH).
How big is your downside if you guess wrong on growth?
BRLI doesn’t have Quest or Lab Corp’s margins — especially in terms of free cash flow (receivables build up has been high) — but it trades at a much lower price-to-sales ratio than those companies. Overall, the big question is again: Is lab testing an industry experiencing some sort of societal bubble? Yes or no. And then do you trust BRLI’s management? And the company’s culture generally? If you’re happy with your answer to those two questions, you can buy BRLI if you’re convinced that it will grow much faster than companies like DGX and LH.
The P/E of 17 means you need to be right on growth to guarantee an acceptable return on your investment. This is not the case at World Acceptance. If it stops being a fast grower, you’d still do alright. There’s a big margin of safety in paying 11 times earnings for a company that has a long record of great growth. So WRLD’s concerns are purely the two questions I keep repeating:
· Is the industry in some sort of societal bubble?
· Does management specifically and the company generally have high enough morals?
If the answer to those two questions says buy WRLD, you’ll end up making a lot of money. For BRLI, this is only true if you also get good growth over time.
What about Peet’s Coffee & Teas?
Yeah. This is why I said price almost doesn’t matter. It matters here. The company trades at more than 45 times its best-ever earnings per share.
It makes no sense to pay more than 40 times earnings for any stock. The pace of growth and the certainty of that growth would have to be so incredibly high to justify paying more than 40 times earnings that there’s little harm in simply applying an absolute cut-off:
Never pay more than 40 times earnings for any stock
Again, the things I would focus on when evaluating a growth stock are:
· The company’s median rate of growth
· The variation in growth
· The frequency with which the company’s growth falls into a sustainable range (10% to 25%)
· The size of the company
· The length of runway the company has in front of it (huge market/tiny company is best)
· The sustainability of the industry within society
· The morality of management and the company
· The P/E ratio (Less than the median P/E for all stocks = Great, P/E over 40 = Never, In between = ?)
Now, some people will complain that I’ve left things out. For one, I didn’t talk about EPS apart from sales growth. In fact, I didn’t even say the company has to be profitable, earning a good return on capital, etc.
Try to generate a list of consistent double-digit growers who’ve been doing it for a decade or more — you’re going to have an incredibly hard time finding any with close to no earnings, unacceptable returns on capital, etc. Some will have only adequate returns on equity — usually because they use no leverage — but all of them will be growing earnings along with sales. Or they will be really odd cases. You’ll be able to separate the truly bizarre stocks from the rest. Most long-term consistent fast growers are pretty similar in terms of having acceptable returns on assets and very few operating losses in their past.
And then what about the P/E ratio? I didn’t talk about the trade-off between how much growth you need to compensate for a higher P/E ratio?
I don’t believe in any of that.
For most people, my recommendation would be simple. Make a list of your favorite growth stocks. Research them exhaustively. Don’t look at their prices. Rank them from the business you like most to the business you like least. Your criteria should be which business would you buy in its entirety if you had to hold it for the rest of your life. Once you have that list, wait until one of those stocks trades at a P/E no more than the median P/E for stocks today.
Buy it. Hold it. Repeat.
Once you start getting into the territory between let’s say BRLI’s P/E of 17 and the absolute cut-off of a P/E of 40 you are in a tricky situation. It is easy to let rather unimportant considerations sway you toward paying 30 times earnings for Company B instead of 18 times earnings for Company A. It’s very hard to quantify the trade-offs involved. It’s totally possible for a company with a more certain future to be a better buy at 30 times earnings than another company at 18 times earnings. And the reverse — that the company with a lower P/E is the better buy — is obviously a possibility. The problem is that you might convince yourself to take on additional risk by betting on a business with an even slightly less clear future just so you can get a lower P/E ratio.
I can’t quantify that trade-off in the real world. In theory, it’s very easy. But that’s because in theory you assume you know the future growth rate. In the real world, you never know the future growth rate.
So my best advice is always to have a list of your favorite public companies ready. And then settle on a P/E ratio that you could live with paying for an average public company.
If you can get one of your favorite businesses at an average price, do it.
Otherwise, just keep looking for the best businesses around.
One day, one of them will trade at a P/E you can live with.
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