Why Analysts Are So Wrong When Evaluating High-Growth Stocks

 |  Includes: AAPL, AMZN, BBRY, INTC, NFLX
by: Robert Wu

Over the past three months, we have seen many analysts cutting Apple's (NASDAQ:AAPL) earnings estimate in a hurry after the stock dropped. Similar patterns have also happened to Green Mountain Coffee (NASDAQ:GMCR), Netflix (NFLX) and many other high-flying stocks. Why are analysts so wrong in evaluating the growth of these companies? In my opinion, three common mistakes are often involved. The first mistake is assuming that high rates of growth will continue for a very long time. This simply cannot be true when a company reaches a certain size. The limited population of its addressable market and the maturity of its products will constrain the growth of any company. One good example is Apple. In March 2012, when Apple introduced a new version of its iPad, the company's stock was being traded at around $600. Almost all analysts at the time were bullish about the stock, leading them to predict unreasonable growth for the iPad. In a blog post from March 14, 2012, titled "Unrealistic Number for Apple," I wrote:

"I read a report today and an analyst is predicting that Apple is going to sell close to 150 million iPads in 2012 and 2013 and will continue to grow 20 percent afterward. It is just unrealistic. The world population is about 6 billion. There are over 4 billion people living under $5/day, and they are not going to buy an iPad. It is basically one iPad for every 10 people if the prediction is correct. (After 20 years growth, the total PC shipments in 2011 are 85 million units.) Even the prediction is achievable, then in 2014 another 110 million units of iPad would have to be sold to maintain 20 percent growth. That's a 70 percent replacement rate (assuming a new iPad comes out). In 2015, it will be 135 million units. This is just impossible. The best reference is the iPod. During the best year, Apple sold 55 million units of the iPod but it only lasted for one year. It went back to 40 million units. The total iPods sold in 10 years is about 300 million. And the growth is negative right now. The only way for Apple to maintain its growth rate is to have new breakthrough products."

Today, it seems so obvious that the projections were not realistic, but at that time nobody was questioning the analysis. You can say the same thing about Amazon (NASDAQ:AMZN) today. The company just cannot grow its revenue by 25 percent per year for long. It would have 90 percent of the U.S. retail market in about 15 years if it did.

The second mistake is underestimating competitors. The first thing I do when analyzing a company is check the barriers for competitors. For most consumer products and retail services, the barriers are low. When BlackBerry (NASDAQ:BBRY) traded at $130, nobody foresaw Apple's entry into the smartphone market. When Apple was at the top of its world, few people would have considered Samsung (OTC:SSNLF) as a threat. It is almost certain that Amazon will have serious challengers, whether Wal-Mart (NYSE:WMT), eBay (NASDAQ:EBAY), Google (NASDAQ:GOOG), or some other company we do not know yet. When venture capital is more widely available, companies have less time to enjoy the successes of their new products and services. Any successful new product or service will attract new companies financed by venture capitalists and mature companies with deep pockets. One company everyone loves is Qualcomm (NASDAQ:QCOM), whose chips are used in 90 percent of smartphones. I will not be surprised to see two or three companies competing fiercely with Qualcomm in the next couple of years. It could be Intel (NASDAQ:INTC), Texas Instruments (TXN) or some other new company financed by venture capitalists. There are exceptions. Some industries have higher barriers to entry, such as drug companies, money center banks and a few others.

The third mistake is using the historic average price/earnings ratio (P/E) to assess the attractiveness of a high-growth company. It is appropriate to use the average P/E to assess mature companies with long histories such as IBM (NYSE:IBM), AT&T (NYSE:T), Johnson & Johnson (NYSE:JNJ), Coca-Cola (KO) and McDonald's (NYSE:MCD), among others. However, using the historic average P/E on a stock that is still maturing can very often lead to overvaluation. It is not unusual for a start-up with a breakthrough product or service to increase its revenue by 100 percent or more for a couple of years, followed by 30 to 50 percent growth for a few more years. In this high-growth period, the P/E could be very high, as high as 50 or more. But almost no company can increase its earnings at an average rate above 30 percent for more than a few years. Amazon has been trading at an average P/E of over 100 for more than 10 years. Expecting this high P/E to continue indefinitely, however, is unrealistic. Amazon just won't be able to grow its revenue at 30 percent annually (not even 25 percent) any more. All high P/E stocks eventually come back to trade at a more sustainable ratio of around 8 to 20. It already happened to Cisco (NASDAQ:CSCO), Intel, Microsoft (NASDAQ:MSFT), Green Mountain Coffee and Apple. It will happen to Amazon, Netflix and other high-flying, high-growth companies as well.

It is important to find out whether a high-growth company is entering the maturing phase. Every company is different, but there are some common signs. The first sign is when a company reaches 10 percent of its addressable population. Netflix is a typical example. There are 300 million people living in the United States. When Netflix reaches 30 million domestic subscribers, its growth rate will come down quickly for its U.S. market. The second sign is when a competitor's products or services catch up with and gain acceptance in a company's own market. For example, Samsung probably single-handedly ended the high-growth era for Apple. The third sign is when a disruptive new product or service enters the market. iPhone ended BlackBerry's growth in the same way that iPad ended PCs' growth. When a growth company inevitably enters the mature stage, investors' expectations should be adjusted accordingly. On the other hand, it is equally unwise to punish a mature company just because of its slower growth. For example, Apple was hit hard when its growth came down, but given its cash position and operating margin, it was undervalued below $400.

In summary, every growth company will come into a mature stage. It is important for analysts to identify when this happens and adjust the valuation matrix accordingly. Investors should always check out competitors and look for signs that there is a turn from high growth to maturity taking place. Do not put all your faith in analysts.

Disclosure: I am long AAPL, INTC. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Additional disclosure: I am short AMZN.