Like many people who (try to) think seriously about investing, I started out obsessed with two things: 1) The Intelligent Investor, by Ben Graham; and 2) the shareholder letters of Warren Buffett. But mainly the former. Graham's book is probably the first thing any investor should read. However, as Buffett himself emphasizes, listening too much to Graham can make you do things like buy a failing New England textile mill just because it looks stupid cheap. And so, in the summer of 2010, I read Common Stocks and Uncommon Profits by Philip Fisher. Fisher was like Charlie Munger is -- he is more of a focuser on innovative growth stocks.
After reading that book I searched around for the best growth stock I could find. I settled on Intuitive Surgical (ISRG), and I first bought into Intuitive Surgical on October 1, 2010, at $286ish/share. Then the price dropped and like a good little new Philip Fisher devotee, I added at $255ish/share on December 13, 2010 because I believed in the company.
Moreover, after things started looking up, I doubled my share count on July 18, 2011, in the neighborhood of $365/share, if memory serves. This was also on the advice of Mr. Fisher, who said not to be afraid of a great stock just because it has gone up. (As you might be able to tell, Mr. Fisher, while wise, also provided the intellectual underpinning, decades later, for the "who cares what the P/E is" dot com bubble of the late 1990s.)
Today the price per share stands at $585.92, and the question is whether I can at all convince myself that future growth justifies additional purchases at this time.
To review, when I was first buying, ISRG traded at $283.74. That represented a very reasonable price-to-earnings-growth ("PEG") ratio of 1.1. The PEG ratio is very important for a growth stock. That also represented more than $100/share (>25%) off the then-recent 52-week high. The P/E was 36.2, the forward P/E was "only" 27.3.
Through today, ISRG has exhibited every bit of the growth I expected of it in 2010 and 2011, and more. Unfortunately, the appraised value (i.e., the market share price) has grown even faster. As stated above, the shares trade at $585.92/share. Also, reflecting their "faster than fundamental growth" appreciation, the all-important PEG ration has now expanded to 1.6. That is not insane, but it is not nearly as good as 1.1. Furthermore, the P/E is now 47.4 (!), and the forward P/E is 37.1. In other words, in every sense the stock is now much more expensive relative to its growth and earnings.
A price-to-earnings ratio of 47.4 means it will take 47.4 years, if growth levels were to remain the same, for you to make back your original investment based on the earnings of the company. Chew on that for a moment. Forty-seven years ago, it was 1965, and America was starting to ramp up for the Vietnam war.
My preferred tool, however, is a discounted free cash flow analysis. Discounted free cash flow analysis is not as useful for growth stocks as it is for stalwarts with highly predictable free cash flows. But I think it nevertheless provides a useful and concrete indication of what level of growth an investor needs to reasonably expect, and for how long, in order to view a stock like this as a good deal.
I reran my free cash flow spreadsheet the other day. I use ISRG's reasonably-calculated WACC of 10.8% for my discount rate. I add in the roughly $1 billion in cash-on hand as of the end of 2011. I assume a 2% perpetuity growth rate. The sheet shows that from 2004 through 2011 the company grew its free cash flow at a truly insane 85% annualized rate. However, most of that growth was early on. From 2009 through 2011 the growth was "only" a 33.87% rate. That is still stupendous, but clearly the company's growth is already slowing quite a bit.
With that in mind, here is the sanity check:
- For you to think ISRG is fairly-valued today, you need to be confident that it can grow its free cash flow by greater than a 21.3% annualized rate for the next ten years; and
- For you to think you are getting it at a 20% discount to its intrinsic value, you need to believe ISRG will grow by around 25% annualized for the next ten years.
The first assumption above is what the spreadsheet is currently set up to reflect, as of Friday's closing price. (Note that the "present share price" in the sheet is auto-updating via Google Finance, so it will change from today's level of $585.82 over time, which you will notice if you view this article and sheet long after I wrote it.)
I should also note I have one issue with the company's reported cash flow sheet. This is that a lot of operating cash flow comes from "stock based compensation." Basically, the estimated final value of stock options must be expensed on the income statement, but issuing stock or options does not require actual cash. Therefore, the amount expensed is added back on the cash flow sheet.
I get it. It's a Young Tech Company thing. It's an accounting convention to get us back to 'true' net income. However, the the granting of options is ultimately a claim on my future free cash flows as a shareholder, once they are exercised. Because of that, I have a hard time crediting the company with the full amount of this portion of free cash flow. I am not going to let it freak me out, but I have my eye on it.
But back to growth. You need to ask yourself, if you own ISRG or are considering buying some: do you think this company can grow at a greater than 21% annualized rate for a decade, through 2022? Do you?
I thought so when I bought it a year and half ago, and then nine months ago, both times at vastly lower price multiples (even though they seemed high at the time). For how long can that 10-year growth forecast keep getting shifted out in time? That is what is happening of course. With every burst of growth that ISRG shows, investors keep shifting the expected high-growth party out in time.
The problem, as we saw with people who bought Microsoft (MSFT) and Cisco (CSCO) shares in 1999 or 2000 at >50 price-to-earnings multiples (not so far from where ISRG is today), is that you do not want to be the last investor to the dance when the growth expectations finally do slow.
Personally, I think ISRG has TONS of growth left. My question is whether it has an entire decade of >21% growth ahead of it. On that basis, I think ISRG is pretty richly valued right now. It is, as they say, "priced for perfection." Think about how long a decade is. A decade ago 9/11 had just happened, and the second American-Iraqi War had not yet started. Personally, I intend to hold my shares, monitor the company, but not add more at this time. I am looking for a pullback.
However, the purpose of this article is not really to take a strong position either way on ISRG's growth prospects. Rather, my goal is to provide a framework, to tell you the investor how much growth you need to expect, and to ask whether you are comfortable assuming that amount of powerful and prolonged growth can actually be achieved.