Under Armour (UA, Financial) is the fastest-growing sports apparel and footwear maker in the world. The company grew so fast it has recorded 25 consecutive quarters of 20%-plus revenue growth.
Thanks to such over-the-top performance, the question of overvaluation always hangs ominously over potential Under Armour investors before they decide to pull the trigger to buy.
Under Armour is now trading at a huge 49 times forward earnings, and the company’s price-earnings (P/E) TTM ratio stands at 70 after the company went through a massive correction during the first half the year. The stock is down nearly 25% since last year but is still trading at a P/E of 70, making it clear that the market is expecting it to keep the growth pace going even if there are minor hiccups along the way.
For a long-term investor, however, it will be a harrowing experience, especially if he or she decided to buy Under Armour last year. The stock has dropped nearly one-third of its value and is still trading with a high P/E. As sales grow the stock will catch up with what it lost, but investors have to accept that they are in for a roller-coaster ride and not a smooth and steady cable car trip to the top.
Why P/S is better than P/E in some cases
For any growth company such as this, it will be a huge mistake to base our decisions on P/E ratios. Take Amazon (AMZN), for example. In order of priority, the retailer always picks cash flow over profitability. Amazon wants to expand at such a fast pace that the company is less concerned about its profit margins than about how much extra sales it can generate each quarter over the period before. Salesforce (CRM) is another great example of a company preferring top-line growth over bottom-line expansion.
So, instead of the P/E multiple, price to sales (P/S) is a better metric to help understand how much extra you will pay for the company’s stock. Under Armour’s P/S TTM ratio is 3.80, nearly a full point higher than Nike’s (NKE, Financial) 2.89. And that’s where the level is after dropping more than 25% in the last 12-month period.
The footwear and apparel market has plenty of room for all players to exploit; although Under Armour’s 20%-plus growth record has to come down at some point it is not going to come crashing down, simply because of the kind of market it operates in. If an apparel and footwear company has the ability to challenge Nike in the U.S., then it can definitely repeat that feat in any other country in the world.
What to expect from Under Armour moving forward
But there’s one important difference between Under Armour and either Amazon or Salesforce in that it is not as aggressive when it comes to expansion over profitability. The company has kept its operating margins steady at around the 10% to 11% mark for the last five years, and as it keeps growing there will be plenty of opportunity improve that metric.
I do not expect Under Armour's sales to slow down in the short term, but it will have to come down to a more reasonable level in the next 10 years. That implies that the P/S valuation has to come down toward that of market leader Nike.
Unfortunately the margin of safety is thin with Under Armour even after the company dropped so much this year. Under Armour is a great company at a bad price. Adding small amounts of stock over a long period of time would be the best way to build your position and insulate yourself from that roller-coaster ride with such a great company.
Disclosure: I have no positions in the stock mentioned above and no intention to initiate a position in the next 72 hours.
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