Wow, talk about a tough market! Last week's column included a list of nine companies recently featured on the Foolish 8 idea list that were all showing relative share price weakness. A week later, all but one of the nine stocks are trading even lower. Forget about relative weakness -- that's absolute weakness any way you cut it.
As was mentioned last week, there is a potential upshot to relative price weakness in stocks. In my eyes, the main benefit of the Foolish 8 small-cap idea list is that it gives the small company investor a bunch of new investment possibilities to research each month. Once the research is underway and a familiarity with an individual company is established, you can then wait for the market to offer a "good" price, or a price that represents a discount to your own appraisal of fair value. In the small-cap world especially, relative price weakness will invariably set in and increase the chances of achieving a pricing discount, just as it is for many former Foolish 8 idea stocks right now.
However, relative price weakness doesn't automatically create slam-dunk stock bargains. The price of any stock can theoretically always go lower, right down to $0 per share. Relative weakness does lower the performance bar, so to speak, a company will need to hurdle in order to generate a specified return over time. This can be seen regardless of the forward-looking valuation yardstick employed, whether an earnings expectations model such as the Foolish 8's 2x/3y formula used in previous columns or even the well-known price-to-earnings-growth (or PEG) model.
To see how relative price weakness can affect the inputs for both of these models, we'll turn to supply chain efficiency software developer Manhattan Associates (Nasdaq: MANH) as an example. This column has relied on Manhattan as a guinea pig in past columns on setting expectations for small-caps and using an earnings expectations model. No need to rock the boat and change from the norm, so we'll use Manhattan as the example again today. Moreover, Manhattan was one of the stocks that made it onto last week's relative price weakness list and has continued to fall in the past week, shedding nearly another 25%.
Let's start with this column's 2x/3y formula first (which equates to a doubling of a company's market capitalization in three years' time, for a roughly 25% compounded annual growth rate or CAGR.) Manhattan's current valuation is $554 million, and the company reported $16 million in earnings in the recently completed fiscal 2000. That gives the firm a trailing earnings multiple of about 35x. Keeping the multiple constant, here's what the company would need to do financially to double its market cap three years out:
- Earnings @ 35x multiple needed to yield $1.1 billion market cap in three years = $32 million
- Fiscal 2000 earnings = $16 million
- Implied three-year earnings CAGR = 26%
Compare this result to the implied three-year earnings CAGR needed when we ran the same calculation for the company on January 9 with the market cap at $1.2 billion. At that valuation, Manhattan would have needed to produce a three-year earnings CAGR of 52% to produce a 2x/3y result, even with the help of a higher ending multiple of 40 times those third-year earnings. So, with its new lower price, the company needs to grow its earnings at half the rate demanded just two months ago to achieve the same 2x/3y result. All else equal, the lower the implied future earnings growth rate, the greater the likelihood a pleasant yet unforeseen upside earnings surprise will occur down the road, although such an event is far from a sure thing.
From a PEG perspective, the picture also looks markedly different than it did earlier this year. The last time we looked at Manhattan Associates, the company was trading at 75 times its soon-to-be-reported fiscal 2000 earnings. That figure was more than double the long-term secular growth rate estimate of 30% given by analysts surveyed by First Call. Today, the company is at 35 times trailing earnings and management recently forecasted fiscal 2001 EPS growth between 32% and 43%.
A typical PEG analysis hinges on the view -- shaky in some investors' minds while rock-solid in others -- that a company's fair value P/E will be close to its earnings growth rate, so long as the firm is growing at rate of roughly 20% or more annually. If you buy into such a relationship between P/E's and growth rates (and that's a big "if"), then Manhattan is looking to be close to "fairly valued" right now. Of course, just like this column's 2x/3y expectations model, PEG is only one way to look at the situation. Further, its conclusions are dependent on the accuracy of the inputs. In this case, that includes a future earnings growth rate that may change as the year unfolds.
For the small company investor, the more models you can use to look at the valuation question, the better. No model is a silver bullet, as no model can include and appropriately adjust for every variable that may effect a company's market valuation over time. As a former Fool writer once put it, "Blind allegiance to models and numbers, divorced from the financial context from which they spring, is never a good policy." The 2x/3y expectations model and the PEG ratio are simply two different ways of looking at the same picture, and neither is necessarily the "right" way. Still, during times when prices are falling, the attractiveness of that final picture is what counts for the small company investor.
Brian Graney's Irish grandmother was named Peg. At the time of publishing, he did not hold shares of any of the companies mentioned above. The Motley Fool is investors writing for investors.
