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Today’s investors have seen their share of bubbles. The philosophy of “investment at any price” has ruined careless and overzealous investors who ignored valuation. That being said, growth companies can command higher valuations from rational investors who believe high growth rates in the short term are reasonable.

Looking at the consumer sector, there are several growth stocks with high valuations. Expedia Inc. (NASDAQ:EXPE), Tempur-Pedic International Inc. (NYSE:TPX), Priceline.com Incorporated (NASDAQ:PCLN), Whole Foods Market, Inc. (NASDAQ:WFM), and Netflix, Inc. (NASDAQ:NFLX) all trade at price-to-earnings multiples that are higher than the S&P 500 (NYSEARCA:SPY) price-to-earnings multiple of 13 (trailing twelve months). By many valuation metrics, they look very expensive:

Ticker

P/E (ttm)

P/E (forward)

P/S (ttm)

P/B

Dividend Yield

TPX

19.66

14.47

2.89

29.33

0

EXPE

17.51

12.21

2.09

2.64

1.00%

PCLN

34.29

16.44

6.63

12.14

0

WFM

31.65

25.97

1.07

3.71

0.70%

NFLX

54.77

31.37

4.27

33.98

0

Are these companies' current prices cheap or expensive? Consider Tempur-Pedic International Inc. (TPX). This company has high valuations and trades at a price-to-book ratio of 29.33, a price-to-sales ratio of 2.89, and a price-to-earnings ratio of 19.66 (trailing twelve months). The firm has experienced 13.08% annualized growth over the past 5 years, and analysts predict 14.38% annualized growth for the next five years. Does future growth justify paying more now?

There are a few ways to attack this question on the basis of returns. An investor could consider how future growth would decrease the P/E ratio in the future, essentially betting that valuations will improve with earnings growth. The investor would be able to sell the stock for a profit only if buyers were willing to pay for the stock at reasonable multiples. If investor sentiment had soured, the investor would either have to hold the stock or take a loss.

We can model this process using a three- or five-year holding period, since above-average growth estimates are not reliable further out. A price-to-earnings multiple of 16 is a little higher than the historical market average, and will be assumed as the valuation upon sale. Many of these firms will still be considered growth firms three or five years in the future, and a 16 price-to-earnings ratio is conservative for growth companies.

Dividend yield will be assumed to be reinvested into shares of the company. Earnings growth over the holding period will be taken as the lesser of earnings growth over the last five years and earnings growth projected by analysts for the next five years. Using the smaller of the two will lead to conservative estimates. These growth rates are used to calculate terminal price-to-earnings ratios, that is, price paid today divided by earnings at the end of the holding period.

3 Years Growth

5 Years Growth

Ticker

Growth (Past)

Growth (Future)

Terminal P/E

Annualized Return

Terminal P/E

Annualized Return

TPX

13.08%

14.38%

13.60

6%

10.63

10%

EXPE

7.20%

11.03%

14.21

4%

12.37

5%

PCLN

51.72%

23.18%

18.35

-4%

12.09

3%

WFM

9.00%

17.23%

24.44

-13%

20.57

-9%

NFLX

45.10%

31.38%

24.15

-13%

13.99

-1%

This analysis shows how growth investors who pay high valuations can fail to reap a reasonable return, even with phenomenal growth. TPX and EXPE are the most defensible investments, even though they have much lower earnings growth rates than PCLN and NFLX. This is because they have the lowest valuations of the stocks considered, not because they have the best growth outlook. PCLN and NFLX fare better than WFM, which currently trades at a high price-to-earnings ratio and has a lower growth outlook than either PCLN or NFLX.

TPX and EXPE are reasonably priced, but PCLN, NFLX, and WFM do not provide acceptable returns for bearing stock risks. Investors in PCLN, NFLX, and WFM must bet on extended long-term abnormal growth rates, high market multiples upon sale, or both. Though these hopeful outcomes are possible, they should not be relied upon.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: 5 Fast-Growing Consumer Stocks Worth Their Price Tags