by Brian Sozzi
Investopedia explains that when the price to earnings multiple (or PE) is high the market is expecting higher future growth. A low PE multiple reflects a company that has fewer earnings growth prospects. Many investors are trained to love low PE rated stocks because of a perception they are receiving a Warren Buffett type long-term bargain. I continue to caution investors that a "cheap" stock is cheap for a reason. Chances are the company has underperformed key rivals on earnings growth in prior periods from a lack of product innovation and inefficient operations (this applies to a trailing P/E multiple). That same company may be stuck in the mud, causing analysts to model for below industry growth rates in the future (this applies to forward P/E multiple). The opposite could be said for a company with a high PE multiple. More likely than not, a company that boasts a high trailing and forward PE multiple has a strong product, best in class management team, and a tightly run ship therefore allowing it to command a premium relative to peers.
However, what is "cheap" and what is "high" when it comes to PE multiples? A stock trading at a single digit PE multiple may not be so cheap as its future growth prospects are muted. A high PE multiple stock may be overbought. The market is essentially a voting mechanism on prior and future company performance. I urge investors to not be fooled by high or low PE multiples. It's imperative to compare company PE multiples relative to others in the sector of interest, historical measures, and future operating potential. Remember, a stock is only "cheap" if a case could be made that growth can surprise the masses that have baked negativity into the stock price. Do your homework, and understand thoroughly the story behind each company in which you invest. An example of a stock that many trumpet is cheap is appliance maker Whirlpool (NYSE:WHR). After you read my assessment of their earnings results yesterday, you make the decision if the stock is worthy of its current valuation.
On my 2Q10 Whirlpool earnings note, I pointed out that the market would look to re-price the stock to account for a slower growth story in the U.S. and an intensification of other external headwinds (input cost inflation, renewed consumer hesitance on big ticket appliance purchases, sluggish sales at distribution channels). Click to enlargeSince that July 20 report, Whirlpool shares are down close to 7%; without much fanfare, Whirlpool shares have shed 30% of their value from the late April 2010 52-week high. I am now reluctant to maintain a bullish thesis on the stock (despite its eye-catching high-single digit PE multiple) ahead of negative earnings related items metastasizing. Those items include: (1) management team seeking to utilize the price lever to remove excess inventory days in 4Q10; (2) foreclosure delays, consumer pullback on appliance spend, and slower global demand may be more pronounced in coming quarters; (3) margin comparisons not getting any easier and with top line growth moderating globally, consensus will have little incentive to move estimates higher; and (4) inflation has arrived at a time when Whirlpool may have to become increasingly competitive on new product launch prices.
I downgraded my recommendation on the stock to Hold from Buy to reflect a tapering in my FY10 and FY11 EPS assumptions. Multiple compression is warranted on Whirlpool with FY11 set to be a down year for margins. Though the stock trades at a PE multiple of 9.0x my new FY11 EPS estimate, I question how cheap that in fact is when drilling into Whirlpool's 3Q10 and going through the multitude of headwinds forming.
- How good are the numbers: Whirlpool reported net sales of $4.52 billion (consensus: $4.49 billion), +0.5% y/y, and a noticeable slowdown from the 1Q10 run rate. Adjusted EPS was $2.22, surpassing consensus by $0.44, and aided heavily by Brazilian tax credit monetization. Whirlpool's reported gross margin missed consensus by 54 bps; excluding the tax credit tailwind and the gross margin shortfall was even greater. Price/mix and inflation globally took their collective toll.
- Segment rundown: North America (first y/y sales decline in three quarters; unit shipments outpaced the industry by 400 bps, but at the expense of price); Europe (sales underperformed industry unit shipments ex. currency); Latin America/Asia (positive stories continued, though growth cooled).
- Broader Items: Lower price/mix globally as well as higher commodities prices impacted results; reduced North American unit shipment guidance by 200 bps from prior guidance; quality of adjusted EPS beat compared to consensus (operating income adjusted missed consensus; tax credit monetization a large piece to puzzle); strong inventory increase y/y going into a slowing sales trajectory.