In the "Intelligent Investor" Benjamin Graham lays out the case for being a defensive investor or an enterprising investor. He goes on to lay out guidelines and analysis techniques an investor can use to make investment decisions. One of these comes in chapter 11 where he discusses basic security analysis without rewriting his tome on security analysis. This article will be a brief application of the formula for valuing growth stocks he provides as a quick method to estimate a value for Groupon (NASDAQ:GRPN). While not a rigid application I hope this adds value to the discussion on Groupon by providing another viewpoint on where the stock price is in relation to current and future value.
The Formula and assumptions needed to make the calculation
Graham provides a basic formula in the section entitled "Capitalization Rates for Growth Stocks" (page 295 of the 2003 edition) that is:
Value = Current (normal) earnings x (8.5 plus twice expected annual growth rate)
Immediately issues and objections can be raised by the reader familiar with both Graham style analysis and Groupon. First, Graham used conservative methodology to determine normal earnings, using historic earnings and tried to normalize swings in the earnings. Second, Groupon has not reported annual profitable earnings yet-so any use of a negative earnings number would naturally result in negative values. Third, what is the annual expected earnings growth rate-both from a negative base and with professional analysts' estimates having a large variance over the next five years?
Graham encouraged conservatism and caution for two good reasons. First if the investor uses caution and estimates turn out to be on the low side, the positive surprise only increases the future return while still meeting or exceeding expectations. Second, he pointed out that when future estimates are large or have large variances, small errors can be compounded and could have disastrous effects. Reviewing the formula above shows one effect of this-when doubling the future estimated earnings growth then multiplying earnings by this number plus 8.5 even a 2% lower earnings growth could cause a wild swing.
So it's time to make some assumptions to make the formula "work" and try to make some valuation estimates for Groupon, then compare our results to current stock price and future price estimates. Looking at analysts' opinions from NASDAQ.com and Yahoo! Finance, the 2015 earnings are estimated to range from $.05 to $.27 per share. NASDAQ.com also provides a 5-year earnings growth estimate of 26.6%. This number masks one cautionary feature-many analysts estimate large earning growth in 2015 and 2017 but zero growth in 2016. To keep numbers round without introducing even more variance, here is the formula with some information added:
Groupon value = earnings x (8.5+53.2) or earnings x 62
So let's do this-math that is
So we have a fairly simple tool we can enter various estimated earnings with a consensus earning growth multiplier and make some forecast values. First, modifying the formula with current price of $8.04 (as of 3/24 per Yahoo! Finance) we divide 8.04/62 to show the stock is priced as if Groupon was earning $.13 this year-well above estimates. Looking at other earnings estimates, these results are generated:
Earnings Formula valuation
As this short table shows, the low estimate of $.05 shows Groupon is significantly overvalued even after recent losses, while the best case estimate results in a doubling from the current stock price. The current price range over the past few days relates to a valuation near the mid-point of earning estimates for 2015.
So now what?
Based on the more conservative estimates, and the fact that Groupon has yet to report positive annual earnings my opinion is Groupon is overvalued by "Mr. Market" at its current trading price of $8.04. Future earning estimates and earnings growth have such wide differences that the stock could be anywhere from 50% undervalued (most optimistic) to 250% overvalued based on forecasts for the next 20 months. For a Grahamite "Intelligent Investor" Groupon is far too risky at the present. As many comments and writers point out, Groupon could double by late 2015 or early 2016, but I feel this is based more on momentum and the higher earning estimates. Could Groupon's stock price double (or more) over the next two years? Yes, but the valuation model provided by Graham must be pushed nearly to breaking to show why. However, each investor is encouraged to conduct his or her own analysis on top of this article and make their own decision. As always, there are two sides to every trade and I hope your trades work out well!
Update: Despite being called a "short", I recently initiated a small position in GRPN and immediately wrote near term at the money calls to capitalize on the option premium and earnings this week. So I now have "skin in the game" on GRPN for those who have called out my warnings and caution!
Disclosure: I am long GRPN. 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.