Over the past few years, you haven't had to look very hard to find an investor grumbling that the various Internet-induced stock bubbles or manias went against the ideas of "traditional valuation." In fact, some observers wondered if the basic idea of valuing a stock had been chucked out the window entirely. Recently, valuation has come back with a vengeance and it is now a hot-button issue for many investors. So, it may be helpful to spend some time examining valuation's place in small-cap investing and how an investor might want to go about valuing a small, fast-growing company.

As stated in last week's column about selling based on valuation, there are two main moving parts to any valuation analysis of a company -- your own expectations about the future performance of the business and the market price of the business as expressed by the daily stock quote. Anytime you compare your expectations for a business to the price currently offered by the market, you're doing valuation work. The first element of the valuation exercise you can control, but the second is largely out of your hands (unless you happen to be someone who is into manipulating stock prices.)

It makes sense that improved expectations about higher future profits will cause your valuation of a small company to rise. But the market isn't always so logical about things. Thanks to the concept of illiquidity, a small company's stock price can shift dramatically in the short-run due to the everyday fits and starts of the market. Try as you might, there's just no getting around the fact that your own personal valuation of a company, no matter how insightful or well constructed, has no bearing whatsoever on the market price. Unfortunately, a stock doesn't know you own it, and the market flat-out doesn't care.

This point has been made all too clear recently to investors in Manhattan Associates (Nasdaq: MANH), a small supply chain technologies company that has been a fixture on the Foolish 8 list since mid-summer. Thanks to a string of four estimate-beating quarters, Manhattan's shares rocketed from $7 3/8 per share at the start of 2000 to a high closing price of $71 5/16 by late October. But since then, the shares have lost nearly 50%, even though the business itself hasn't hit any noticeable speed bumps. What gives? The market seems to be saying Manhattan was "overvalued" in October, and that it is more properly valued today. But are those two interpretations correct? If you owned Manhattan and didn't sell at the recent top, did you make a mistake?

One way to approach valuation questions like these is to think about stock prices as representing future expectations. Thankfully, the Foolish 8 method gives us a starting point to structure expectations about a company's future growth. By requiring year-over-year earnings and revenue growth rates of at least 25%, we can place some bounds on our expectations for a small company. Due to the wonders of math, something growing at a 25% rate compounded will end up doubling in about three years. With the close historical correlation between earnings growth and stock-price appreciation, it doesn't seem unreasonable then to expect that a small cap growing its earnings at least 25% annually should see its market price double in three years.

With this model in hand, we can now look at the expectations that were built into Manhattan's stock price at its October high and compare them to the expectations suggested by the price currently. Manhattan's market capitalization (share price multiplied by shares outstanding) at the October high was $2.2 billion. So for the market cap to double in three years, as our expectations model dictates, here's what would need to happen to the firm's earnings, using an aggressive but not outlandish growth company multiple of 40 times earnings:

  • Earnings @ 40x multiple needed to yield $4.4 billion market cap in three years = $110 million
  • Estimated fiscal 2000 earnings = $17 million
  • Implied three-year earnings CAGR = 86%

What this means in plain English is that at its October high, Manhattan would have needed to grow its earnings by 86% annually to double its market cap in three years. Compare that computed earnings growth rate to the growth rate implied at today's prices, with the company's market cap now at $1.2 billion instead of $2.2 billion:

  • Earnings @ 40x multiple needed to yield $2.4 billion market cap in three years = $60 million
  • Estimated fiscal 2000 earnings = $17 million
  • Implied three-year earnings CAGR = 52%

What do these calculations tell us, besides that math is fun? Like any model, the idea behind using an expectations model is not to arrive at an automatic final answer, but to gain additional perspective that can be used to make a valuation judgment for yourself. Making a final call on whether Manhattan was or even still is overvalued -- and to what degree -- largely depends on your personal comfort with the different elements of the model being used and the implied growth rates that are spit out. Next week, we'll take a closer look at these issues and try to make our own judgment on the questions surrounding Manhattan's changing valuation.