By David Sterman
It's one of the first rules of investing: find stocks with strong earnings growth and reasonable valuations. We're even taught a simple formula: look for stocks that have a price-to-earnings (P/E) ratio that is lower than the earnings growth rate, or, a PEG ratio (P/E divided by the earnings growth rate) lower than 1.0.
Yet the converse is also true. Stocks with a PEG ratio over 1.0 can be overvalued. It happens without many investors even noticing. A stock rises and rises until its value becomes disconnected from the reality on the ground. A high PEG ratio can limit further upside and make a stock especially ripe for a pullback in down markets. On the flip side, it can also make for a nice stock to short.
Here's a look at three stocks with alarmingly high PEG ratios. Each of the stocks on this table trade at least 50% above fair value when the PEG ratio test is applied.
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This provider of contact relationship software has seen its shares fall roughly 10% since I profiled it two months ago. Yet shares still look really expensive. If you assume that the company can boost profits by 20% every year, it would take eight years for the P/E ratio to fall down to the earnings growth rate -- assuming the stock went nowhere in that time.
Salesforce's bulls are counting on the company's current initiatives to help set the stage for accelerating growth. But they're ignoring "the laws of big-ness." As a company gets larger, it gets harder and harder to maintain aggressive growth rates. Just ask eBay (NASDAQ:EBAY) or Wal-Mart (NYSE:WMT). Years of torrid growth have been replaced by ever-slowing growth for those firms. That may not happen for Salesforce.com in 2011 or 2012, but counting on nearly a decade of very strong growth yet to come seems foolhardy.
During the prior seven years, this chip designer mostly traded in the single digits. But in the past two years, it has risen roughly 300% to a recent $24. Why the breakout? Its chips (and licensed designs) are finding their way into an increasing number of smart phones. The company toiled for years to get other chip makers to use its technology and had a banner year in 2010, currently counting 34 licensees for its communications-based intellectual property.
Yet investors are likely getting carried away, pushing shares up to more than 40 times projected 2011 profits and about 30 times likely 2012 per share profits of $0.80. Many are mistakenly viewing Ceva as being on the cusp of a sustained long-term expansion. But this industry is characterized by an ever-changing landscape of winners and losers. Momentum in any given year is eventually lost as rivals steal back market share. For example, Ceva saw sales nearly double in 2003 to $36 million, yet by 2009, they were still below $40 million.
Sales now look headed up again to $60 million by next year thanks to recent design win momentum, but are likely to hit a cyclical peak at that point. Indeed rivals such as Taiwan's MediaTek are pushing back with their own design upgrades while also maintaining lower licensing price points. There's no reason to expect Ceva to see sales and profits slump, but long-term growth also appears deceivingly robust. When reality sets in, sharers are more likely to generate a mid-teens multiple, pushing shares back down toward the $15 mark.
Sears Holdings (NASDAQ:SHLD)
Most of the companies on the table above can at least boast of near-term solid growth prospects. But this retailer looks to be going the opposite way, heading into a long-term secular decline. Management has been much more focused on financial maneuverings such as stock buybacks than in keeping stores fresh and competitive. The Kmart division looks especially weak, as its stores haven't been upgraded for quite some time.
Shoppers are voting with their feet. Sales are on track to fall for the fourth straight year in the fiscal year that ends this week. Analysts expect sales to fall yet again in the coming fiscal year. That's why the equivalent of 10 days worth of daily trading volume is held in short positions.
Yet the company has its supporters. Sears has been buying back so much stock that shares outstanding have fallen from 155 million in 2007 to a current 110 million. Were it not for buybacks, per share profits would be falling even faster than the 12% decline currently forecasted for the coming fiscal year. Nevertheless, profits that are falling faster than sales are a sure sign that a retailer is struggling with the negative effects of overhead de-leveraging.
As long as management allows the store base to languish, further sales erosion appears inevitable. Profit weakness could be even more profound. So why are shares trading for 66 times projected (January) 2012 profits? The reasons are unclear to me. Goldman Sachs predicts shares will fall from a current $75 to around $54 as the company's dismal long-term outlook comes into sharper focus. UBS is slightly more charitable with a $56 price target, predicting bad news ahead: "Sears could see a return to high single-digit negative comps beginning in the (first quarter) through (the second quarter) as the company begins to lap the appliance stimulus benefit of last year."
Investors tend to fixate on near-term trends. But you need to understand how the future will play out in order to stay ahead of the crowd. In the instances noted above, the long-term view doesn't remotely justify the near-term P/E ratios. Any one of these stocks could make for a ripe short candidate.
Disclosure: Neither David Sterman nor StreetAuthority, LLC hold positions in any securities mentioned in this article.