Shares of 3D Systems (NYSE:DDD) are up an astounding 149% over the past year compared to a 27% return for the S&P 500. So just what exactly caused this incredible rally? I'll give you a hint: It wasn't related to 3D System's business results. Before diving into the exact cause of the rally, it's of the utmost importance for investors to understand the two factors that cause stock prices to go up or down in the crazy fun place we call the stock market.
Mr. Market's fun house
The day to day movement in stock prices can be chocked up to a multitude of factors, but movement over the short to long term really boils down to two factors -- the company's operating performance, and what the stock market thinks about that performance.
When it comes to how the company is performing in its operations, the most popular measures are earnings, sales, and cash flow. These operating results should be looked at on a per-share basis because investors don't own the whole business and need to make sure they're not being diluted. A company can do amazingly well but investors won't get to participate in that success if the company continually issues shares, thereby diluting value for shareholders.
The second factor, and the most often ignored by investors, is how the market feels about the company's operating results. Mr. Market expresses his opinion of a company's current and future results in the form of multiples. The most popular multiples are price to earnings, price to sales, and price to free cash flow. These multiples can change quickly with Mr. Market's manic mood swings, and in the short term have the largest influence on a stock's price. Here's a illustration of how this works in the market.
As you can see the stock price is equally dependent on both the company's past performance and how the market feels it's going to do in the future. In 3D Systems' case it works out like this: $87.80 = 188.74 x $0.46. Which means that the price of 3D Systems' stock ($87.80) is equal to its price to earnings multiple (188.74) times its earnings per share ($0.46).
Now lets do an example of what would happen if the stock market changed its mind and assigned a price to earnings multiple of 50 to the company's stock, the price would be: $23.00 = 50 x $0.46. As investors can see, the market's "feelings" can impact a stock's price far more quickly than a change in the company's operating performance. This is because it's far easier for a multiple to move by a large amount than a company's operating performance.
Now lets see which of these two factors influenced 3D Systems' stock price the most over the past year.
How 3D Systems' business did in 2013
3D Systems was a very busy corporation this year and continued its aggressive acquisition spree of the following companies:
- Xerox Solid Inks
- Village Plastics
- The Sugar Lab
- CRDM Ltd.
- VisPower Technology
- Phenix Systems
- Co-Web SARL
The company also released a plethora of new products, ranging from huge industrial printers to entry-level scanners. All of this led to a 4% decrease in earnings per share, an 11% increase in sales per share, and a 20% decrease in free cash flow per share from December 2012 until today. At first glance it's hard to see why shares would increase 149% with those kinds of operating results for investors.
Mr. Market's profound fascination with 3-D printing
The real reason behind the company's share rally didn't have much to do with the company's operating results; rather, it was due to Mr. Market raising his expectations for 3D Systems by 159%. That increase is equal to the increase in the price to earnings multiple for 3D Systems' stock over the past year. Remember from the example above, 3D Systems' price to earnings multiple went from 50 to 188 which had the effect of increasing the share price by 149%.
Basically, the stock market is predicting that the company is going to grow very quickly over the next three to five years. Judging from analyst estimates and predicted industry growth, the company will need to grow its operating results by greater than 26% per year for the next three to five years on average in order for Mr. Market not to get upset.
What does it all mean?
A huge risk in investing is when Mr. Market drastically changes his opinion about how well he thinks a particular company or industry is going to perform, which is also known as multiple contraction. This principle was made famous by investing legend Phillip Fisher in his book "Common Stocks and Uncommon Profits". For example, if an investor buys a stock in a "hot" industry and the market assigns a price to earnings multiple of 50 to it but in the next year decides to assign a multiple of 25, that company's earnings will need to increase by 100% in one year in order to offset the decrease in the multiple and for investors not to lose money.
The stock market loves 3D Systems' stock right now and has assigned an extraordinary multiple of 188 times price to earnings. Even at 2014's predicted earnings of $1.11 per share, the market is assigning an incredibly high multiple of 80 times price to earnings. In my opinion, a successful investment in 3D Systems at today's price is incredibly risky due to what I perceive to be unsustainably high trading multiples, and the risk that operating results fail to keep up with the Mr Market's current expectations.
In the video below Motley Fool analyst Blake Bos covers this topic in detail and offers investors his view on how to handle this complex situation.