The problem with basing investments purely on PE multiples is that it all too often discards growth stocks or firms just entering free cash flow profitability. A perfect example of when multiples fail is the casino business. If one were to make an investment decision based on PE multiples, one would think MGM Resorts (MGM) was a much greater value play than Las Vegas Sands (LVS) and Wynn Resorts (WYNN). After all, MGM only trades at 2.2x past earnings versus 27.3x and 23.9x for Wynn.
As it turns out, the free cash flow trajectories at LVS and Wynn is stronger than what is the case for MGM. In my free cash flow model on LVS, I assume several factors: (1) growth hovering between 36.2% and 20% over six years, (2) operating metrics at historical levels, (3) a 1.5% perpetual growth rate, and (4) a 10% discount rate. Based on these assumptions, I find the fair value to be $68.04, which is at 31.7% premium to the close of trading on May 12, 2012. I find free cash flow hitting around $6B by 2017, which is 14.2% of the current market value.
My assumptions for Wynn are a little more reserved with 14.2% per annum growth modeled over the explicitly projected time period. Ultimately, I forecast free cash flow trending from $1.2B to $2.3B by 2017, which is 20% of the current market value. Both of these are attractive price-to-free cash flow multiples.
Wynn and LVS are both led by top managements - Billionaires run the operations of these companies. Emerging market expansion well position these companies to outperform broader indices.
With that said, MGM still has an attractive turnaround story going for it. 2011 was very promising with revenues and EBITDA both up by the double-digits as MGM China showcased a breakout year. And while the company is expected to lose $0.47 per share in 2012, free cash flow was still positive at $374M in 2011 when the company bled $0.56 per share. In fact, free cash flow actually grew by double-digits in 2011. Yet again, basing investing decisions on multiples shows its flaws.
Estimating price targets based on earnings exit multiples thus often requires investments to go beyond the "better-than-14x-or-bust" mentality of myopic value investors. In terms of growth, fundamentals, and free cash flow trajectory, LVS and Wynn both merit a PE multiple of around 21x.
Consensus estimates for LVS' EPS forecast that it will grow by 27.7% to $2.58 in 2012 and then by 20.5% and 18.3% in the following two years. Assuming a multiple of 21x and a conservative 2014 EPS of $3.63, the stock would hit $76.23.
Consensus estimates for Wynn's EPS forecast that it will grow by 5.7% to $5.90 in 2012 and then by 15.8% and 14.1% in the following two years. Assuming a multiple of 21x and a conservative 2013 EPS of $7.69, the stock would hit $161.49.