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 computer and electronics retail (and one that's actually lost sales) 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
GameStop (NYS: GME)
10.9% / 15.4%
hhgregg (NYS: HGG)
15.4% / 23.6%
Systemax (NYS: SYX)
10.4% / 19.8%
Best Buy (NYS: BBY)
15.5% / 21.7%
Rent-A-Center (NAS: RCII)
8.1% / 10.7%
RadioShack (NYS: RSH)
11.6% / 20.3%
Source: S&P Capital IQ.
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:
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. For example, I listed RadioShack in the table even though its sales growth has been negative. Why? Because its five-year EPS growth has been strong. While I don't see big growth ahead for either Radio Shack or Best Buy, I actually like their futures better than GameStop's (the top past sales grower) at current valuations. Hence, I own shares of both. That said, my Foolish colleague Jim Mueller may disagree since he's bullish on GameStop.
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 Radio Shack and Best Buy. You can follow his thoughts on Twitter. The Motley Fool owns shares of Best Buy, GameStop, and RadioShack. Motley Fool newsletter services have recommended buying shares of hhgregg. Motley Fool newsletter services have recommended writing covered calls in GameStop. Motley Fool newsletter services have recommended writing covered calls in Best Buy. 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.