Raise your hand if you remember the great Dolby (NYSE: DLB ) debate of 2007.
In May, I loosened the reins on my imagination a bit, transcribing a fictional discussion of the sound specialist's stock between Mad Money's Jim Cramer and alleged "D.C. Madam" Deborah Jeane Palfrey, who had petitioned a judge to allow her to sell her Dolby stock to pay some legal bills. The pundit took Dolby's side, arguing that the company's strong double-digit growth justified its price. Meanwhile, the madam (er, "alleged madam," says my lawyer) worried: "I believe it's reached its peak. I don't want it to waste away."
Well, as it turned out, the pundit and the alleged madam were both right. The stock did proceed to lose 10% of its value -- but as of today, it's won back all its losses, and more, and currently sits above the fateful $37 marker at which my version of Palfrey wanted to sell. The catalyst, of course, was yesterday's earnings news, in which Dolby announced that it had transformed 28% year-over-year revenue growth into nearly twice that amount of profit growth in its fiscal third quarter.
Moreover, things are going so gangbusters that management again raised its estimates for the current fiscal year. As of yesterday evening, it now expects to book as much as $475 million in sales, and perhaps $1.11 per share in profit.
Don't choose a life of prostitution
Now, I know what you're thinking: The madam was right! (Ah-ah-ah! Remember -- alleged madam.) You're thinking that with a current price-to-earnings ratio of 34, against analysts' projected 19% growth in profits, Dolby is woefully overpriced, and it's sure to waste away, just as my debate's Palfrey predicted.
But that's not necessarily so. Remember that the business often generates significantly greater cash profits than it reports as net income under generally accepted accounting principles. That hasn't been the case so far this year -- the two numbers are almost precisely equal. But over the past 12 months, free cash flow was sufficiently robust to give the firm a price-to-free cash flow ratio (P/FCF) of only 29. (For comparison, Sony (NYSE: SNE ) scores a 93 P/FCF, SRS Labs (Nasdaq: SRSL ) has a 39, and DTS (Nasdaq: DTSI ) has negative free cash flow.)
While I'll grant that this still makes Dolby look like no bargain, neither does it mean the stock is overpriced relative to the market. Divide the P/FCF by its estimated growth rate, and you come up with a figure of 1.5. Meanwhile, the S&P 500 itself carries both a lower P/FCF (18.3) and a lower implied growth rate (12.6%) -- which combined make it not that much cheaper than Dolby itself -- 1.4.
So does Dolby's new and improved price make it a "sell"? Perhaps. But if you decide it is, you should probably sell the entire stock market as well. There's really little difference in the valuations -- at least by that imperfect measure.
Can't get enough of Dolby? Surround yourself with the sound of earnings news:
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Fool contributor Rich Smith does not own shares of any company named above.
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