Last week, we started looking at the recent changes in the market's valuation of Manhattan Associates (Nasdaq: MANH) using a simple model that takes into account expectations about future earnings growth. Using this model, we were able to see that as Manhattan's share price has fallen over the past two and a half months, so too has the earnings growth rate the company needs in order to double its market capitalization in three years. But the column left some questions about Manhattan's valuation unanswered. Specifically, was Manhattan in fact overvalued at its October peak? And thus, did Manhattan shareholders miss an ideal selling opportunity?
Before trying to answer these questions, it's worth pointing out that "overvalued" is a dangerous investing term, mostly because it means different things to different people and thus creates ample opportunity for confusion. My own take is that there are degrees of overvaluation and that it's not an either/or proposition. It's not like being pregnant -- you can't be slightly pregnant or incredibly pregnant. You're either pregnant or you are not. Overvaluation, on the other hand, is not so black and white. Moreover, it's not always the terrible thing some investors make it out to be.
There's nothing inherently wrong with buying a stock when it's reasonably valued and continuing to hold onto it even if it becomes somewhat overvalued for a spell. That view might startle some, but I think it's a frame of mind that investors need to accept if they want to invest successfully in small-cap stocks for any period of time longer than a year. Stocks can get ahead of themselves sometimes, and fast-growing small-caps are particularly susceptible to periodic run-ups in their share prices. In hindsight, it's easy to see price peaks on a chart and think to yourself, "Wow, what a golden opportunity to sell." The flip-side to this rearview mirror thinking is that selling yesterday prevents you from realizing even bigger gains tomorrow, and that's the key point to always keep in mind with small-caps.
If you look at things from a forward-geared perspective rather than one locked on the past, questions about overvaluation start to become a matter of degree. In other words, the right question to ask is whether Manhattan was grossly overvalued at its October peak. To answer this, we need the context and guidance of our own expectations about the future. That's where an expectations model comes in handy. By setting some parameters about future expectations, you can better judge the likelihood of achieving an appropriate return. With small caps, we're looking for high returns, on the order of 25% annually if possible.
Picking up where we left off last week, our expectations model indicated that Manhattan at its peak would have needed to generate roughly 86% compounded earnings growth over the next three years to realize 25% annualized stock appreciation over the same span. At its reduced price today, the necessary earnings growth rate is about 52%. Ordinarily, both of these figures would seem scary, if it wasn't for the market Manhattan is serving and its impressive growth rate currently.
The company's core supply chain efficiency software product, called PkMS, is hot right now. That popularity has allowed Manhattan to generate $28 million in free cash flow through the first nine months of 2000, more than double its reported net earnings over the same span and four times the amount of free cash flow generated in all of 1999. The company's balance sheet currently shows a cash heap of nearly $60 million just waiting to be invested in other high-growth opportunities and no debt. Gross margins in Q3 were close to a historical high. After Y2K fears caused a growth hiccup in 1999, the evidence shows that Manhattan has shifted back into hyper-growth.
Given that backdrop, an expectation of 86% annual earnings growth over the next three years may still appear quite high to a rational individual, but it's not exactly far-fetched either. Although it's wrong to infer too much from the past, there's at least a high-growth precedent as the firm's pre-tax income rose at a 68% compounded annual rate between 1995 and 1998. Granted, Manhattan will have an easier time achieving 52% growth in the future than 86% growth. But given the business' prospects, I don't think there is enough evidence for a reasonable person to conclude that Manhattan was grossly overvalued at its October peak or that it's grossly overvalued today. In other words, the company's price tag may be high given the future earnings growth rate implied by our model, but it doesn't seem ridiculously high.
Of course, all of this overvaluation versus ridiculous overvaluation talk may seem like splitting hairs to some folks. It all depends on what happens in the future, something that is and always will be unknowable. And just because Manhattan doesn't look grossly overvalued at its current price of around $40 per share doesn't mean it won't look that way three or six months from now. As investors found out in 1999, conditions in Manhattan's market and its business can change dramatically in no time.
But remember what we set out to prove in this column. The goal was to look at Manhattan's valuation at its peak and determine if it provided enough justification to sell the stock. Since the peak valuation appeared high but not ridiculous based on our earnings expectations model, I don't think a sale would have been warranted. By no means does that conclusion somehow mean that the stock is priced reasonably today or that small-cap investors should rush out and buy it at current levels.
In the end, valuation comes down to your own personal expectations of how the business will perform in the future. Using a simple earnings expectations model is one way to arrive at those future expectations and then use them to make a sound judgments about a company's valuation today and down the road.
