The price/earnings ratio is one of the best and most used metrics for determining the cheapness or richness of a stock's valuation. But investors should not place too much emphasis on this metric because it is only a snapshot and it should only be used as a starting point for investment research. This figure does not incorporate the future growth or sustainability of past earnings. Below is a list of companies whose stocks should remind us of the limited explanatory power of price/earnings. Each stock could be much cheaper than their high price/earnings multiples make them appear.
Dendreon Corp (DNDN)
Price/Earnings (ttm): n/a
This company has the most expensive price/earnings of the companies on this list because it actually lost money over the last year. But DNDN has major upside hidden behind its seemingly preposterously rich valuations. The company is the maker of PROVENGE, a late stage prostate cancer drug. Not only does this drug's label use serve a sizeable market, its off-label use could have explosive potential down the line. According the American Cancer Society, prostate cancer is expected to affect more than 240,000 new cases this year, with 34,000 men expected to die from the disease. With a $93,000 price tag on the drug treatment and a recent decision from the Centers for Medicare and Medicaid Services to allow coverage for the treatment, it should be obvious to investors that the upside is massive.
In addition, one of the company's main inhibiting factors has been insufficient supply to meet the stronger than expected demand. This past month, the FDA approved the company's Seal Beach California production facility. This plant nearly doubles the company's productive capacity from 48 workstations to 84 workstations. This figure some continue to increase this year as the Atlanta facility could be approved by the FDA as early as August 28, 2011. New drug production will ramp up this year and in coming years.
We are not alone in our belief that the stock is cheaper than the high P/E suggests. The company's stock price jumped from $2 in March 2009 to a current price of around $37. Despite this, lots of smart money investors are still bullish of this stock.
Sirius XM Radio (SIRI)
Price/Earnings (ttm): 210.01
We are bullish of SIRI because it has structural advantages over competitors. These factors should continue to fuel the company's fundamental investment thesis. But one of the most under appreciated bullish tailwinds is the company's hidden pricing power. Because of their settlement in the Blessing v.. Sirius XM case, the satellite radio company agreed not to raise subscription prices until 2012. This has effectively inhibited trailing earnings, but creates a significant springboard for fundamental upside in 2012 and 2013. As we previously speculated in "5 Cheap 'No Sweat' Stocks to Keep you Cool in the Summer," just a $1 monthly rate increase could lead to a 20% increase in the stock price.
In addition to the above mentioned fundamental stock price driver, we think it is useful to note that the company still has an elevated level of short interest. As of July 15, 2011, the company had 274,572,534 shares sold short. This should continue to benefit long shareholders because this indicates a strong level of bearishness and because it suggests that there is a strong group of guaranteed future purchasers of this stock.
Green Mountain Coffee Roasters (GMCR)
Price/Earnings (ttm): 131.02
The maker of the popular namesake coffee and Keurig brewing system is one of the market's most expensive and popular stocks. Please spare us the angry emails, because not that long ago we were also bearish of this company. We have not turned bullish. As value oriented investors we just will not allow ourselves to buy into stock whose value is so predicated on future potential. But this could very well be to our detriment because the company has awesome technological advantages as well as secular opportunities here and abroad. The company stands to benefit significantly from the move towards at home single cup coffee makers. In addition the company's business model is akin to the famous Gillette razor model where men purchased the shaving set and then made subsequent purchases of replacement blades. With Green Mountain, consumers purchase the Keurig brewing systems and then purchase single serve coffee cups. As such, revenue growth at a company like this means much more than it would at a typical company because revenues GMCR are essentially guaranteeing future revenues.
In the most recent quarter, the company sold 1.1 million Keurig brewers, contributing to a 66% jump in brewer revenues from a year ago period. In addition, gross margins during the quarter actually increased from 34.4% to 36.8% because of the changing sales mix. This was generally glossed over by market watchers, but this is important. The company's sales are becoming increasingly driven by coffee cup sales and not brewing machines. This trend should continue and margins should actually continue to increase along with revenue growth. This is an uncommon combination because sales growth is often driven by declining margins. The fact that the company expects 60% to 65% sales growth in 2012 as well as improving gross margins explains the market's bullishness for this company.
Finally, there is a hidden upside if the fundamental story is not enough. In March 2011, GMCR entered into a strategic partnership with Starbucks Corp (SBUX) to sell the coffee giant's branded coffee and Tazo teas in GMCR's proprietary single serve coffee cups and brewing systems. This was a big coup for both companies. On the one hand, Starbuck estimated that 80% of Starbucks customers do not use single-cup brewers. As a result, this partnership gave SBUX access to a big untapped market. On the other hand, it gave GMCR a major partner and additional asset in their coffee portfolio. Last but not least, it gives GMCR shareholders a potential near term catalyst if SBUX decides to acquire them down the road to take advantage of their tremendous potential domestically and abroad.
Price/Earnings (ttm): 97.23
Amazon.com presents one of those frustrating investor situations. The company is great, but the stock is pricey. And let me be clear that we have a hard time buying the stock even though we LOVE the company. Still, there are reasons to think that the stock is cheaper than its high P/E suggests. First, the revenue growth is amazing. In their most recent quarter, the company grew sales 51%. While bears and skeptics will remind us that AMZN sacrificed margins to grab revenues. For example, operating margins plummeted from 4.11% to 2.03% in the last year. Still, there is a very strong bull counterpoint. AMZN is building itself into a juggernaut and as such, sales growth in and of itself strengthens the company because it strengths their competitive advantage over smaller retailers. In this regard, it may be bullish for the company to chase revenue growth. Disagree with us? Name one company that you view as a real competitor to the company's business.
But of course, a company of this size does not garner a pricey P/E just because of high sales growth and low margins, the Amazon.com bull story is more nuanced than that. They are growing rapidly domestically and abroad. This is not the typical rapid international growth but stagnant domestic growth story. North America sales grew from $3.59 billion to $5.41 billion in the recent quarter and international sales grew from $2.98 billion to $4.51 billion during the same period.
Last but not least they have an interesting technology segment in Amazon Web Services (AWS). During the most recent quarter, revenues grew to $359 million from $203 million a year ago. On an annualized basis, this segment generates around $1.5 billion in sales. Rackspace Hosting, Inc (RAX) trades at a price/sales of 6.33 and Equinix, Inc (EQIX) trades at a price/sales of 3.71. While these companies are not perfect comparables, we think it provides us with a useful ballpark.
Because of AMZN's strong growth and brand recognition, they could grow AWS quickly. If we place a price/sales of 5-10x on that segment, it could be worth $7.2 billion to 14.4 billion.
Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in SIRI, GMCR over the next 72 hours.