A lot of research goes into selecting the right stocks for your portfolio. For instance, there are dozens of sources of relevant information for Keurig Green Mountain (NASDAQ:GMCR). By the time you've read a half-dozen annual reports, listened to quarterly conference calls, checked up on competitors, and, of course, stopped by to see what The Motley Fool has to say about the stock, you may have accumulated too much information to process it intelligently.
When you get to this stage of information overload, it's time to step back and look at it from a different angle: Ask what kind of return you need from an investment in Keurig, determine how well Keurig needs to perform to generate your required rate of return, and then decide if the performance you need is likely to be delivered. I've done an analysis for Keurig below, but you can substitute your own numbers to judge for yourself.
Step 1: Choose a rate of return
Some people go to great lengths to choose the appropriate rate or return -- or discount rate -- to apply to a given stock, but I'm a fan of simplicity. Choosing a somewhat arbitrary return, like 10%, is often as good as doing a detailed risk analysis to come up with the appropriate discount rate for each stock you analyze. If you want to be scientific about it, you might require individual stocks to give you a higher return than an S&P 500 index fund.
Let's use the latter method to determine the minimum return we want from Keurig's stock. We're long-term investors, so let's figure out what long-term return we might get from the S&P 500.
If you had invested $1 in the S&P 500 on June 2, 1950, it would have grown to $108.82 -- dividends included -- on June 2, 2014. That's a 7.6% compound annual growth rate, or CAGR, over the 64-year period. So 7.6% might be a minimum return we'd want from Keurig.
Another way to estimate the S&P 500's likely future return is to measure past returns for each 10-year period. For example, if you bought and held the S&P 500 from June 1, 2004 through June 2, 2014, you would have received a 5.4% total return. If you held it for any 10-year period since 1954, chances are you'd end up with a 6.6% return. Each market environment is different, but history shows us that we can usually expect a 6.5% to 7.5% total return from the S&P 500 over a 10-year holding period.
Let's choose 8% as our required minimum rate of return for Keurig, just to be safe.
Step 2: Calculate necessary growth rate
In step two, we need to figure out how quickly earnings per share need to grow in order to meet our required rate of return. The key assumption in this step is in choosing the terminal price-to-earnings ratio -- the earnings multiple we believe the stock will receive in 10 years.
Keurig Green Mountain currently trades at 30 times analysts' estimates of next year's earnings. However, the terminal multiple should be much lower because the market will have lower growth expectations for Keurig in 10 years. Since mature cash cows tend to trade at 15 times earnings in normal market environments, let's assume Keurig trades at 20 times earnings in 2024 -- a multiple that suggests the company will still be growing at an above-average pace in 10 years.
Keurig's stock trades near $120 today. The stock price needs to be $259 in 2024 to deliver an 8% annual return for today's stockholders. If Keurig trades at a 20 price-to-earnings ratio in 2024, it needs to earn $12.95 per share that year. Analysts estimate that Keurig will earn $3.78 per share in 2014, so earnings per share must grow 13.1% per year for it to reach its earnings target.
(Keurig also pays a small dividend -- $1 -- which yields less than 1%. You can take it into consideration if Keurig's expected return and your required rate of return are close, but it's simpler to leave it out for now.)
Step 3: Determine if the company can grow quickly enough to meet the target
Few companies can grow faster in the future than they did in the past, but that's not a frightening limitation for Keurig shareholders. Since 2007, Keurig has grown earnings per share by no less than 26% in any single year -- well above the 13.1% growth necessary to achieve an 8% return for shareholders.
Unfortunately, that growth rate appears to be slowing down. Analysts expect the company to earn $4.03 per share in 2015, just 6.6% higher than their 2014 estimate. So, it appears that Keurig's investment merits depend on earnings growth derived from new product introductions, namely Keurig 2.0 and Keurig Cold.
Now you know what you need to investigate: How much growth will Keurig's upcoming brewers generate? My analysis suggests that Keurig Cold will contribute no more than $4.43 in earnings per share in 2024. If you can accept that, then you need to figure out if Keurig 2.0, 3.0, etc. will contribute at least $8.92 per share in 2024. If it can, then Keurig's stock price will probably outpace the broader market.
While most of your research is spent evaluating the qualitative aspects of companies (Does the company have a durable competitive advantage? What do its customers care about? Will its new strategy work out? etc.), it sometimes helps to make a quantitative evaluation to check yourself. It's easy to get wrapped up in the hysteria regarding Keurig's new equity investor, potential partnerships, and upcoming product launches.
Looking at the hard numbers anchors your analysis in something tangible, allowing you to determine whether or not a long-term investment in the stock is likely to turn out well for your portfolio.
Change my assumptions, insert your own, and justify -- or rule out -- an investment in Keurig using this quantitative check. It will help you understand what bet you're really making when you invest in Keurig today.
Ted Cooper has no position in any stocks mentioned. The Motley Fool recommends Keurig Green Mountain. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.