In late 2002, Quality Systems
The compelling valuation included accelerating revenue and income growth (30% and 40%, respectively), a price-to-earnings multiple of 22, and enough cash on the balance sheet to buy back 20% of the outstanding shares.
Conservatively assuming that revenue growth would slow, Tom used a growth estimate of 20% to value the shares. But then revenue growth didn't slow. Now, the stock is up by more than 350% since the original recommendation.
My point, however, isn't to brag about Tom's gain, but to examine the value present in two separate offerings. The P/E of 22 in March 2003 has turned into 47 today. That has put quite a premium on Quality Systems' growth prospects. Is it justified?
If you had invested back in March '03, the underlying stock still would have been a value, even if revenue growth had quickly slowed. The margin of safety cushioned the potential downside.
But at the current price, it's more of a high-risk, high-reward scenario. If revenues continue to grow at a high rate, margins should expand. That would cause even higher net-income growth and would most likely reward investors with large gains in the share price. On the flip side, if revenues slow, the stock could plummet.
The risk lies with sales growth. Investing at this price, you had better know exactly why customers are buying and why they might stop. This involves examining the customer, the competition, the technology, the political regulations, and many other factors. For an example of how sales growth can slow in a given year, check out the past five years of revenue numbers from some of Quality Systems' competitors: Cerner
That's not to say that Quality Systems can't do well from its current share price. With net income growing at 62% in the most recent quarter, strong cash flow, and products in high demand, the company could very well beat the market from here.
It is easier and safer to invest when the growth prospects are discounted, though. Since these situations are so much harder to come by today than they were in early 2003, some investors may decide to pay up for a fast grower. Doing so might yield high returns, but then there's the downside. It's best to be patient and wait until the market offers a margin of safety.
It's worth noting that the price of Quality Systems dropped 15% midday Thursday on no news. (The P/E ratios above have been adjusted to reflect the change.) That's as good an example as any you'll ever get of how quickly the market can offer you a discount.
Although a firm date hasn't been set, Quality Systems' fourth-quarter earnings release should be out within the next two weeks. Check fool.com and the QSII discussion board to be sure you don't miss it.
Fool contributor Matt Thurmond owns no shares in any company mentioned.