Stock prices are based on expectations. The faster a company is believed to be growing, the more investors are generally willing to pay for a slice of the business. It makes perfect financial sense. A guaranteed positive cash flow of $1 this year, $2 next year, and $4 the year after that is worth more than one of $1 this year, $1.10 next year, and $1.21 the year after that. In fact, discounted at an investor's required return rate of 10%, the first set of cash flows is worth $5.57, while the second is worth only $2.73. This chart shows how it works.
|
Year |
Raw Cash Flow 1 |
Cash Flow 1, Discounted |
Raw Cash Flow 2 |
Cash Flow 2, Discounted |
|---|---|---|---|---|
|
1 |
$1.00 |
$0.91 |
$1.00 |
$0.91 |
|
2 |
$2.00 |
$1.65 |
$1.10 |
$0.91 |
|
3 |
$4.00 |
$3.01 |
$1.21 |
$0.91 |
|
Present Value Totals: |
$5.57 |
$2.73 |
The key difference between the two is the growth. In both cases, the hypothetical company is expected to deliver $1 this year. The expected cash in the subsequent years really delivers the difference. Since the cash flows are guaranteed, the value of each choice is obvious, and the first one is worth far more than the second.
So what?
In the real world, things don't operate with that level of certainty. The stock market's principle is the same -- the faster a company is expected to grow, the higher its multiple to near-term earnings -- but the future growth is never known for sure, until it gets reported as historical financial data. This means that growth rates baked in to stock prices are quite often wrong. Bad growth estimates and bad stock valuations go hand-in-hand.
Back in January, when Google (NASDAQ:GOOG) topped out at around $475 a stub, the market was basically pricing in annual growth rates of around 100% for at least the next four years. With $6.14 billion in trailing annual revenues, doubling each year would require the company to book more than $98 billion of annual sales by the end of the fourth year. But according to JMP Securities, the online advertising budget for the entire world is expected to be just $65 billion by 2010.
Reality check
In other words, to justify Google's January highs, the market was projecting unreasonably rapid growth. Wall Street presumed that Google would own 100% of all online ads plus diversify and dominate in other revenue-generating models. Sure, Google is moving into paid services like video streaming, but it's still not enough.
Don't believe me? Apple's (NASDAQ:AAPL) iTunes Music Store recently announced its billionth download. At around $0.99 a song, that amounts to a shade less than $1 billion since iTunes was launched. If Google could dominate the online music-download market along with online advertising, it still wouldn't be enough. Even surpassing Amazon.com (NASDAQ:AMZN) in online retailing wouldn't do the trick. After all, Amazon pulled in a mere $8.5 billion in revenue last year.
So for Google to have been worth $475 a share this past January, it would have had to be in a position to dominate online advertising, online paid downloads, and online merchandising by 2010. Add resistance from the entrenched competitors in those industries, then throw in existing search, email, and portal competitors like Yahoo! (NASDAQ:YHOO) and technology titan Microsoft (NASDAQ:MSFT), and you begin to see that Google's fall from its pinnacle was inevitable.
How you can profit
Just as the stock market overestimates some companies' growth rates, it underestimates others' potential. Since anticipated growth largely drives a company's current stock price, too pessimistic a picture can send its shares tumbling well below the firm's true worth. When that happens, you can swoop in, buy, and then wait for the market's excessive pessimism to be revealed.
This strategy is known as value investing, and it's exactly what we do at Motley Fool Inside Value. Philip Durell employed this strategy in recommending Fannie Mae (NYSE:FNM). The mortgage giant has been surrounded by an enormous amount of pessimism. It faces the potential that Congress may limit its operations, thanks to the fallout from its derivatives accounting scandal. And rising interest rates could knock out the housing market that it relies on for its business. With problems like that, the market is absolutely scared out of its wits about this company, and it's pricing it accordingly. Philip thought this might be a place to profit, with the potential to beat absolutely lousy expectations.
The Foolish bottom line
Companies' stock prices are driven by the market's expectations of their futures. If the market's projections forecast perpetual, rapid growth, be wary. Any surprises are likely to be negative and will send your investment downwards. On the flip side, if Wall Street is expecting stagnation, any growth will be a positive surprise, thereby improving your likelihood of profiting.
Are you ready to stop paying too much for growth that never materializes? Click here to start your 30-day free trial to Inside Value, and learn how to find companies that are trading so low that nearly any surprise will be a positive one. Subscribe today, and we'll not only knock $50 off our regular price, but we'll also send you a copy of The Intelligent Investor, along with access to the Fool's Stocks 2006, absolutely free.
Microsoft and Fannie Mae are current Inside Value selections. Amazon is a Motley Fool Stock Advisor recommendation.
At the time of publication, Fool contributor and Inside Value team member Chuck Saletta owned shares of Microsoft. The value of the Fool's disclosure policy can't be overestimated.
