The investment takeaway from thisearnings season is
unmistakable: Growth is slowing as companies do their best to
ensure that current sales don't fall below the levels seen in late
2011. And this changing growth dynamic is slowly causing investors
to reconsider what kind of stocks to own. Value plays with
considerablebalance sheet ordividend support are getting a fresh
look, while high-growth business models are now under ever-greater
Chipotle Mexican Grill (NYSE:
as an example. Roughly six weeks ago,
that "Chipotle's 2014P/E is now higher than its
forecastedearnings growth, which is a key marker of overvaluation."
Sure enough, Chipotle soon delivered downbeatprofit guidance for
2013, andshares have tumbled lower by nearly $100.
Though comparing earnings growth to a price-to-earnings (P/E)
ratio may seem to be an over-simplified analysis of a stock's true
value, it actually has a great deal of relevance -- at least in a
qualitative perspective. Let me explain.
Richly-valued stocks are valued on their long-term growth
prospects, and not on their near-term earnings prospects. Indeed
you'll find many good companies that generate little or no profits
early in their development. Investors give them a pass. Yet as we
saw in the case of
, that pass expires the minute that growth slows, and quite
suddenly P/E ratios start to matter.
Now, using Chipotle as an example, not only have analysts had to
lower their long-term profit assumptions for this restaurant chain,
but they have also had to lower a likely targeted P/Emultiple on
that lowered P/E forecast.
For example, when I wrote about Chipotle on Sept. 20, it was
trading at $340, or around 31 times projected 2013 earnings of
$10.90 a share. Analysts eventually had to lower their 2013
earnings outlook to $10.42 per share, a decrease of about 4%. But
only few figured the stock still deserved to trade at $340 a share.
Instead, shares have fallen by a hefty 26% to a recent $250. Why
this sharp price drop? Because it represents a 2013 P/E ratio of
around 24 times projected 2013 profits, which is much closer to the
projected 17% profit growth that analysts now anticipate for
That's why, in thismarket environment, you need to think twice
about owning any stock that sports a high P/E multiple. These
companies may be able to grow faster than most, but they are still
likely to feel the effects of a slowingeconomy -- and may see their
P/E ratios compress over time.
I went looking for the most richly-valued stocks in the S&P
500, those that trade for more than 30 times projected 2013 profits
and more than 25 times projected 2014 profits. These 10 stocks
Ultra-high P/E ratios
The view into 2014 is essential to confirm whether these stocks
areovervalued . For example, Netflix is making heavy investments in
an international expansion, so 2013 profits are being dampened,
leading to the appearance of an exorbitant P/E ratio. Yet even into
2014, when international divisions will no longer be dragging down
profits, this stock is still quite expensive, trading at roughly 50
times the 2014 profit view.
is another example where earnings didn't matter in the past, but
soon will. Amazon recently delivered downbeat guidance, leading the
2013 consensus earnings forecast to drop from around $2.30 to $1.80
per share. Analysts at Merrill Lynch trimmed their 2014 earnings
forecast from $5.16 to $4.68 a share -- higher than the $3.80
per-share earnings consensus. To justify a stock price that still
trades at such a rich forward multiple, investors have to assume
that Amazon's profit growth will be very strong in 2015, 2016 and
beyond. Yet it's fair to wonder whether Amazon can continue to grow
at such a fast pace, now that it is so large.
These same concerns can be spelled out for companies like
Intuitive Surgical (Nasdaq:
Whole Foods Markets (NYSE:
. These are great companies with phenomenal track records, yet the
current valuations imply very strong growth still to come, even
though these firms now sport much larger revenue bases than in the
past. One false move, and it's curtains.
Risks to Consider:
The market's recent pullback may just be a pause before the
next move up -- if investors conclude that the U.S. economy will be
on stronger footing in 2013 and 2014. If so, these frothy stocks
can get frothier still.
Action to Take -->
As we've seen with Chipotle Mexican Grill, Netflix and so many
others, richly-valued stocks can get hammered once growth starts to
slow. In this challenging market, the winds are blowing even
stronger as investors shift from "risk-on" stocks to "risk-off." If
you own any stocks in the table above, then you need to stress test
that current forecasts for future growth can be met. If youspot any
trouble signs (such as a warning from a key competitor), then don't
wait around until the music stops.
-- David Sterman
David Sterman does not personally hold positions in any
securities mentioned in this article. StreetAuthority LLC does not
hold positions in any securities mentioned in this article.
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