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Safety Check – How Much Growth is Impounded into Amazon’s, Google’s and Apple’s Stock Prices

July 17, 2014 | About:

Safety Check—How Much Growth is Impounded into Amazon’s, Google’s and Apple’s Stock Prices

Earnings growth rates have a significant effect on the estimated value of a company’s stock. Differences in the returns investors expect from holding a company’s stock can frequently be explained by differences in the growth rate assumptions used. Given a company’s current stock price, an expected multiplier (such as a P/E multiplier), and a specified required rate of return, it is a simple process of inferring whether the earnings growth rate assumption impounded into a stock’s price is reasonable, high, or low.

The process followed here is very similar to that followed by Peter Lynch. He would do this to assess whether the growth assumptions used in his initial analysis of a company’s stock were realistic and, in effect, gain an alternative perspective on the soundness of a company’s valuation (fairly valued, undervalued, overvalued). The example below applies a version of Peter Lynch’s method to Amazon (AMZN), Google (GOOGL) and Apple (AAPL).

Evaluation

Suppose we invest in these companies only for the long-term (let’s say 10 years). The prices of AMZN’s, GOOGL’s and APPL’s stocks are $355.90, $590.62, and $94.78 respectively. For a 10 year holding period, let’s assume we require a return of at least 100%. That is, we assume it is only worth investing into any of the positions for 10 years if the stock price will at least double. To some this might sound high, but really a 100% return over 10 years translates into a compound annual return of only 7.2%, which isn’t that high (and this excludes dividends of course).

 

Current Price

Expected Price (r=100%)

Holding Period

Current (EPS TTM)

AMZN

$355.90

$711.80

10 years

$0.64

GOOGL

$590.62

$1,181.24

10 years

$19.33

AAPL

$94.78

$189.56

10 years

$5.96

Next we must generate assumptions for our P/E multipliers. The multiplier assumptions presented in the table below represent estimates of what P/E multiples the companies could trade at in 10 years assuming some multiplier compression. (Other than for AAPL, multiplier expansion is probably an unreasonable assumption for high growth firms such as these over another 10 year time horizon—though we have been wrong on this before!)

 

P/E (current)

P/E*

P/E**

AMZN

555.6

75.0

30.0

GOOGL

30.6

25.0

20.0

AAPL

16.0

15.5

15.0

The stock prices expected in 10 years divided by the P/E multipliers expected in 10 years tell us what EPS we can expect in 10 years. We can then use this and current EPS data to calculate what EPS growth rates are required on each position for stock prices to double over the period and provide us with our required 100% return (7.2% annual rate of return).

 

g

g*

g**

AMZN

7.2%

31.0%

43.5%

GOOGL

7.2%

9.4%

11.9%

AAPL

7.2%

7.5%

7.8%

Assuming current multipliers are maintained, 7.2% annual EPS growth would provide us with our required 7.2% annual rate of return.

More realistically, especially for AMZN, we will see some multiplier compression. Assuming AMZN’s multiplier compresses from 555.6 to 75.0 over the next 10 years, annual EPS growth would need to be 31% for us to meet our 7.2% annual rate of return requirement. I don’t know how realistic this is given that AMZN’s EPS has been in a state of decline since 2010.

The situations for GOOGL and APPL appear much more realistic. Multiplier compression from 30.6 to 25.0 for GOOGL and from 16.0 to 15.5 for APPL would require annual EPS growth of 9.4% and 7.5% respectively. These growth estimates are far more realistic and are far more aligned with recent growth activities.

The questions that remain for investors are: is a 7.2% annual rate of return sufficient to qualify for investment? Are the multiplier assumptions presented above realistic? And can these firms grow their earnings at the required rates?

If forced to take one position, with net margins of only 0.5% and ROE of only 3.1%, we certainly wouldn’t be putting our money on AMZN.

Disclosure

SEENSCO does not hold any long or short positions in AMZN, GOOGL or APPL.

About the author:

SEENSCO
SEENSCO, a Canadian Corporation founded by Daniel Seens, CFA, is an investment research firm located in Ottawa, Ontario. Our Safety-First approach to identifying and evaluating companies helps investors to protect their principal and generate exceptional rates of return.

Visit SEENSCO's Website


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