Take an objective look at the following three companies. No tickers or company names, just look at some of their basic fundamentals.
|EV to EBITDA||P/E||ROE|
All of them are trading for unheard valuations - two of them have P/Es approaching 100, and one of them has a P/E above 300. Such huge multiples could only be justified by extraordinary competitive advantages and out of this world returns on capital. But none of the companies offer particularly great returns, with only company A having an above average ROE, and at just under 20%, the ROE isn’t exactly world beating.
Now take a look at the companies with the names revealed.
|Name||Ticker||EV to EBITDA||P/E||ROE|
|Green Mountain Coffee Roasters Inc||GMCR||47.78||84.63||14.97%|
With an average EV / EBITDA over 50, P/E over 160, and ROE of just 13%, investors are paying incredible valuations to businesses earning only moderate returns.
Now, everyone knows these are high flying, high multiple names with huge growth prospects. But you would expect the high multiples to be somewhat justified by incredible returns on equity. Clearly, however, that’s not the case.
Maybe you could justify such poor returns if they were on the verge of reaching a critical mass which would propel them to massively higher ROE. Unfortunately, that doesn’t appear to be the case. In fact, their best days may be behind them, as these companies will face fierce competition and headwinds in the near future that could actually slow their growth significantly.
Amazon.com, for example, faces the prospect of losing a piece of its competitive advantage, lower prices vs. physical stores, as cash strapped states look to tax online sales. This will cause Amazon.com to lose some of its price advantage over physical retailers like Best Buy (BBY). In addition, retailers are focused on growing their online business to spur sales. Picking on Best Buy again, the company is focusing on growing its online sales, increasing its online selection and offering something Amazon.com can’t - site to store pick up.
Salesforce.com faces growing competition from Microsoft (MSFT) and other tech giants. While the company so far has managed to hold its own, company insiders may have more doubt than investors over CRM’s ability to sustain that edge - they have been frantically dumping their shares for some time, including unloading over $100m worth of shares over the past 12 months. Investors may be wise to follow their lead.
Finally, Green Mountain Coffee may be the worst of them all. Not only have insiders been selling (albeit, not at the pace of CRM), but the company has been issuing shares hand over fist. Shares outstanding have increased almost 20% over the past three years. Because of that, even with the company's increasing earnings, EPS has barely budged because of the increase in shares outstanding. Not to mention the company is still involved in an SEC investigation and is consistently accused of playing accounting games to make its numbers.
Could these stocks go up from here? Stranger things have happened. But investors should carefully consider the risks and what the price they’re paying before jumping in at today’s prices.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.