Red Hat, Inc. (RHT) is a growth stock that provides a variant of the Linux operating system family, which is formally known as Red Hat Enterprise Linux. (If you haven't heard of Linux, take your IT guy or IT gal out for a cup of coffee.) Unfortunately, Red Hat trades at very high valuation multiples. When compared to its peers, it is readily apparent that investors should stay away from RHT shares at current price levels, even after considering growth projections. RHT high price multiples should dissuade investors from buying at current prices until its valuations descend closer to those of its peers.
Computing Future Valuations from Growth Projections
There are many jaded tech investors who fell for very compelling growth stories. They believed optimistic projections tend to increase the stock multiples beyond reasonable levels. Regardless of how shiny a stock is, investors should never buy a stock because the company is fancy, disruptive, or because it is fun to read about. Instead, investors should be focused on growing the value of their assets. Stories, drama, the next big thing, and other distractors cannot justify paying one dollar for fifty cents.
Instead, investors should buy stocks trading at prices, which make them good deals. A poor company trading at a dismal price may be an excellent trade. Red Hat shares are trading at the other extreme—Red Hat is a great company trading at incredibly enthusiastic valuations, which should be avoided. Its metrics are provided with other software stocks:
Earnings Growth Est.
Sales Growth Est.
Future valuation multiples of RHT and its peer stocks were modeled by combining expected growth and trailing valuation multiples. Graphs of future price-to-earnings and price-to-sales ratios based on analyst earning growth estimates and historical sales growth follows:
Click to enlarge
The projected crossover dates span well into the future, which demonstrates how RHT shares are overpriced. Even assuming that long-term analyst growth rates will continue indefinitely (which is itself ridiculous), it would take 16 years of sustained, phenomenal earnings growth for Red Hat's current price-to-earnings ratio to be equivalent to that of Adobe Systems.
These projections illustrate the absurdity of current valuations for RHT. Analyst estimates for faster-than-economic growth are not predictive after three years or so, yet somehow investors are paying prices for RHT, which implies that they can see the distant future. Investors are more likely overenthusiastic than psychic.
Estimated convergence years were calculated below for RHT:
Investors should avoid Red Hat at current prices. Instead, they should consider other companies on this list as more reasonable alternatives, which can be justified without the absurdity of a decade and a half of sustained, phenomenal growth. In particular, CA Technology is reasonably priced, especially when contrasted with its more expensive peers. Both CA Technology and Oracle have valuations that start at reasonable valuations and have growth trajectories with maintained attractive valuations when compared to industry peers.
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Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.