Why are investors willing to pay only 10 times earnings for some stocks, but 20, 50, even 100 times earnings for others?
The short answer: growth. Companies that can grow their earnings meaningfully could make lofty current P/E ratios look cheap in hindsight.
Of course, any company can promise a rosy, growth-rich future. Figuring out which companies can actually deliver is far trickier. In this series, I take the first step by identifying companies that have put up the best growth track records in their respective sectors.
Below, I've listed the top sales growers in property and casualty insurance over the last five years. Here's how to interpret each data column.
Five-year sales growth: I rank each company's sales growth, to capture its pure trailing expansion without regard to the vagaries of earnings.
Five-year EPS growth: Since sales growth means nothing if it doesn't ultimately fall to the bottom line, I've also included each company's five-year trailing EPS growth rate.
Five-year analyst estimates: This column shows us how much EPS growth analysts expect over the next five years. Just keep in mind that analysts tend to grossly overestimate a company's prospects.
Five-year ROIC range:Return on invested capital basically shows you how efficiently a company is converting its debt and equity into profits. We want companies that can do a lot with a little. By looking at the five-year range, we can start to gauge both the power and the consistency of a company's profit engine.
5-Year Sales Growth
5-Year EPS Growth
5-Year Analyst Estimates
5-Year ROIC Range
Tower Group (NAS: TWGP)
7.9% / 15.8%
Erie Indemnity (NAS: ERIE)
(4.1%) / 16.8%
AmTrust Financial Services (NAS: AFSI)
6.1% / 13.9%
(12.3%) / 19.8%
Meadowbrook Insurance Group (NYS: MIG)
7.6% / 9.2%
National Interstate Corporation (NAS: NATL)
8.3% / 20.1%
Navigators Group (NAS: NAVG)
3.9% / 12.5%
Berkshire Hathaway (NYS: BRK.B)
1.6% / 8.2%
Argo Group International
1.0% / 11.7%
1.4% / 9.9%
Source: S&P Capital IQ. NM = not meaningful; EPS growth that is NM results from losses during the period. N/A = not applicable; analyst estimates that are N/A result from lack of analyst coverage.
Use the table above as a first step to help you generate ideas for your own further research. Once you identify stocks worth a closer look, the following three steps will help you further assess their growth prospects:
I normally instruct readers to carefully study the table for possible danger signs, such as high sales growth but low EPS growth, analyst growth expectations significantly trailing past growth, and low ROIC figures. Then follow the trail. But one thing to consider is that Warren Buffett's Berkshire Hathaway doesn't do too well on the EPS growth and ROIC measures. If you're a Buffett fan, this may seem strange. Here's where industry dynamics come into play. Buffett has long pooh-poohed looking at Berkshire's earnings (which drives the numerator in both EPS and ROIC) for guidance because so much isn't included in that number. For example, his stakes in large companies like Coca-Cola aren't credibly reflected in earnings. Dynamics are bound to confound some of the other companies here as well, since the insurance business is all about investing float. So in this case, I'd look at the table of high-growers for possible ideas, but I'd then delve deeply into the business models and check out other metrics, such as growth in book value per share. For example, lead sales grower Towers Group has increased book value per share by 26.5% over the last five years, while Berkshire has grown it by 9%.
Find out how the company achieved its prior growth: organically or via acquisition? Can it sustain that previous growth?
Pay attention to how management plans to implement its growth plans. Does its strategy seem prudent and plausible to you?
Remember: The more profitable, efficient, and predictable growth a company can achieve, the more we investors should be willing to pay.
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At the time thisarticle was published Anand Chokkavelu owns shares of Berkshire Hathaway. The Motley Fool owns shares of Berkshire Hathaway and AmTrust Financial Services. Motley Fool newsletter services have recommended buying shares of Berkshire Hathaway. 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.
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