So far, 2023 has represented a resurgence of quality growth stocks that were bludgeoned by last year's bear market. Software giant Adobe (ADBE 0.87%) is a prime example. The stock has shot up nearly 70% since the beginning of the year, no easy task for a stock worth a quarter of a trillion dollars.
There are many reasons to love Adobe's business, but it's become increasingly harder to love the stock. Buying an outstanding stock at a poor price can leave investors underwhelmed with mediocre investment returns.
While selling Adobe might be harsh, I'll outline below why investors should avoid putting more money into shares until the valuation cools.
First, let's give Adobe the respect it deserves
Don't get the wrong impression; Adobe is a wonderful company. Most known for its free PDF reader, Adobe Acrobat, the company has evolved into a powerhouse of digital tools to create, edit, and distribute digital content. Adobe today features more than 20 creativity apps distributed through the cloud. Apps like Photoshop and Adobe Illustrator are staples in the marketing departments of most enterprises.
Adobe offers its products on a subscription model, making it an SaaS stock. That model has been remarkably lucrative, putting Adobe on a straight-line growth path over the past decade with robust free cash flow to go with it:
Data by YCharts.
Stellar operating performance has translated to stock price appreciation. Shares are up more than 1,000% over the past 10 years, easily beating the broader market. The fundamentals and returns make Adobe a no-brainer stock idea if the price is reasonable, but that's where things get complicated today.
Shares have gotten too hot
Adobe has some potential headwinds that could slow down its performance in the future. First, moving the growth needle becomes harder as you get larger. Adobe has become one of the world's largest companies at a $256 billion market cap. It will be much harder for the stock to even double from here, let alone repeat its 10-bagger performance from the previous decade.
Secondly, the U.S. job market has gotten increasingly more robust throughout most of the decade, aside from the pandemic. Today, unemployment is near decade lows. A recession or uptick in unemployment could stunt Adobe's business, which sells heavily to other enterprises.
Data by YCharts.
Analysts expect Adobe's earnings growth to average approximately 13% over the next three to five years. The stock trades at a forward P/E of 36, meaning its PEG ratio is nearly 3. This signals that Adobe stock is relatively expensive today for its expected earnings growth.
What can investors expect?
To further illustrate Adobe's problematic valuation, management is guiding for full-year fiscal 2023 earnings per share of $15.70 (at the midpoint). Based on analysts' expectation for 13% annual earnings growth, that figure could grow to $22.65 in 2026.
Suppose Adobe's price-to-earnings (P/E) ratio drops to 25 from its current 36 by that time. After all, the broader market trades at a forward P/E of about 20 and has historically averaged 10% annual growth. In that context, a P/E of 25 looks pretty reasonable for Adobe, which grows slightly faster.
Adobe's share price would be $566 at 25 times 2026 earnings. Today's share price of $562 means investors would end up sitting on the stock for over three years with little to show for it. That might not be a problem if you're investing for the next decade and beyond, but it (at the very least) illustrates what a stretched valuation can do to even the best stocks if the entry price is too high.
Of course, this is all speculation. Nobody knows where any stock will trade in the future. But investing sometimes boils down to putting your money behind stock ideas with higher odds of success than failure. Adobe's lofty valuation has too much potential short-term downside to warrant chasing today's price. Consider looking elsewhere and circling back when the valuation comes down.
