Douglas Lawson - DirectorDouglas Lawson co-founded Amati Global Investors with Paul Jourdan. Prior to this he worked in corporate finance and private equity, initially focusing on middle market UK private equity and listed company M&A at British Linen Advisors, and latterly as an investment manager in the private equity team at Noble. Douglas has co-managed the TB Amati UK Smaller Companies Fund and Amati VCT since 2009, Amati VCT 2 since 2010 and the Amati AIM IHT Portfolio Service since 2014. Douglas started his career at Ernst & Young in London, where he qualified as a Chartered Accountant in 2002. He is a Director of Amati.
Why we buy expensive stocks
Posted by Douglas Lawson on 30/Aug/2017
FevertreeDrinks PLC listed on AIM in November 2014 at 134p per share. This represented a price to earnings (P/E) ratio of 20.6x based on the broker's estimate of full year profits for 2015. Looking ahead to 2016, the broker's forecast put Fevertree on 17.6x. Come the day of the IPO, the shares were soon trading at 166p, pushing these P/E multiples up to 25.5x and 21.8x, respectively. Was Fevertree expensively priced at IPO? Did it become expensive on the day the shares began trading? We didn't think so. We subscribed for shares in the IPO itself, then added to our position shortly afterwards. The share price is now 2425p and, whilst we have been taking profits into this appreciation, we continue to hold a position in Fevertree, even though the stock is valued at 70x current consensus 2017 earnings (and 102x historic 2016 earnings).
The success of Fevertree (1,634% gain since IPO) serves as a warning against being fixated with P/E multiples in isolation. When assessing the valuation of a growth company we look ahead several years in order to determine whether the price we are paying today is a fair one. This is because high growth companies on a high multiple of near term earnings can be trading on a comparatively low multiple of expected earnings in several years time. This is usually not built into market forecasts, which will nearly always factor in a 'fade rate' for growth, meaning current, run-rate levels of growth will decline year on year. These forecasts may therefore underestimate the potential of companies that are capable of delivering extraordinary levels of growth for multiple years. Coming back to Fevertree, at the time of the IPO, forecast earnings per share for the year to December 2016 was 9.6p. The actual result was 23.7p, an incredible 147% above expectations at the time of the floatation. This is an example of the disconnect between what the broker must publish to avoid accusations of conjuring up figures that look unrealistic on paper and the real earnings potential of great growth companies.
When the market latches on to businesses that have repeatedly upgraded their earnings forecasts, the stock tends to 're-rate' meaning that, as well as the earnings forecast climbing up, the P/E ratio also rises. As a share price is a function of the earnings forecast multiplied by the P/E multiple, this delivers a double whammy to investor returns. In today's market, such stocks can re-rate to multiples akin to those of Fevertree. At this stage, investors are right to revisit the valuation question.
So, is Fevertree's current rating of 70x justifiable? It depends. Having delivered earnings growth of 106% in 2016, the market is now forecasting (following upgrades in July) 34% earnings growth in 2017 and 12% in 2018. Given the company's history of upgrades, and the slowdown in growth this would represent, it would be little surprise to see these forecasts moving up again. Let's for a moment take a scenario where a company, like Fevertree (Stock A), is trading on 102x historic earnings. Suppose that company's growth rate slows from 106% in the prior year to 50% for the next 3 years. Looking out 3 years, the P/E ratio falls to 30xx. If you extend this to 5 years, the P/E falls to 13x. Let's compare this to a company (Stock B) on 18x historic earnings that has an earnings growth rate of 5%. If you look at historic or near term P/E ratios in isolation you would conclude that Stock B is significantly cheaper than Stock A. If you model compound annual earnings growth of 5% over 3 years, Stock B is trading on a P/E of 15.5x – it is still cheaper but the discount to Stock A is narrowing. However, over 5 years, Stock B is trading on 14.1x versus stock A on 13.4x. In other words, looking out 5 years, Stock A is cheaper than Stock B and I would be inclined to argue that the growth prospects of Stock A remain better than Stock B.
This approach comes with a number of caveats, not least that a company (like Stock A) that experiences a material slowdown in growth relative to market expectations will not only see its earnings forecasts revised down, but is also likely to be 'de-rated', meaning its P/E rating will fall – a reverse double whammy to the share price. Fundamental analysis and vigilance can reduce an investor's prospects of being caught in this situation, but not eradicate them.
Example earnings per share (EPS) movement: Stock A versus Stock B
Example Price to Earnings (P/E) ratio: Stock A versus Stock B
Source : Amati Global Investors, Fidessa