When share price valuations grow ludicrously high – think of Netflix’s (NFLX) historic PE ratio – it’s easy for investors to lose track of the underlying bet. How many long-term investors who bought Netflix last week understood that its earnings need to rise some 740% in the next five years to meet the Wall Street expectations its share price implies?
Barron’s columnist Jack Hough gave us a good idea of how to look at those expectations in a piece focusing on Netflix, Amazon.com (AMZN) and Salesforce.com (CRM). Share prices for each of those companies have at least tripled in the past five years. Their forward price to earnings ratios are in or near triple digits.
Hough paints pictures of each of those companies in 2017 -- or at least how Wall Street expects them to look, based on analysts forecasts – pointing out the sometimes questionable assumptions on which these forecasts are based. Salesforce.com, for example, is supposed to double or triple earnings in each of subsequent years even though it’s already a big business facing much bigger competition.
A similar analysis might be helpful for investors looking for bargains among some of the very well-performing, highly valued, stocks that have fallen out of favor recently. For example, Chipotle Mexican Grill (CMG) has been a top performer for several of recent years. But is the company going to be so much better off in a few years that its shares today are worth 36 times historic earnings, a generous PE ratio?
We considered what Wall Street expects Chipotle, a $10.12 billion market cap company, to look like in 2015. (Almost no one is ever right about five-year forecasts. They’re rarely right about three-year forecasts either, but they tend to be closer.) Earnings per share are forecast about 73% higher in 2015 than last year, fueled by an approximately 54% gain in revenue. Those profits are expected to rise faster than revenues despite Chipotle’s warnings that current year profit margins will be squeezed by rising food costs. The company is expected to open some 170 or so new restaurants or so, which will of course boost overall sales. But sales are expected to be flat or barely up at existing stores this year. There’s no dividend to mollify investors if earnings reports don’t go as hoped.
Most analysts don’t think even those numbers add up to a PE of 36. Holds, sells and underweight ratings outstrip positive recommendations for Chipotle by almost three to one.
It should be noted that great earnings expectations don’t have to be met for a stock to rise, as long as investors continue to believe that the company has the potential for great earnings. Amazon’s earnings per share have deteriorated since 2010, which was hardly what its early investors were expecting. But it’s doubtful they’re complaining.
Dee Gill, a senior contributing editor at YCharts, is a former foreign correspondent for AP-Dow Jones News in London, where she covered the U.K. equities market and economic indicators. She has written for The New York Times, The Wall Street Journal, The Economist and Time magazine. She can be reached at firstname.lastname@example.org.
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