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A Hundred Times Earnings! Is Your Generation Crazy?

|, Inc. (AMZN) Includes:Apple Inc. (AAPL)

Sophomore: Gramps, you make investments, why would anyone intentionally pay over 100 times earnings for a stock?

G: Uhh . . . to make money?

S: But if most stocks sell at 10, 20, or 30 times earnings wouldn't this one ultimately have to lose most of your money?

G: Yes, if it's P/E goes down that much before you sell it. Why should the P/E go down?

S: Well, that's where most stocks are.

G: So what keeps this one up where it is?

S: Damn-if-I-know. What do you think?

G: More buyers than sellers. Who owns it? Who keeps buying it? Does it trade actively?

S: Well, over 3 million shares trade on an average day, at a price around $250. Yahoo Financial on the internet says corporate insiders own 20% of the company, mutual funds and institutions another 2/3rds and those 872 organizations own 84% of the float. What's "float"?

G: That's stock not owned by insiders or affiliated companies, and presumed to be available for other investors to buy and sell. Perhaps you're looking at, Inc. (NASDAQ:AMZN)?

S: Yeah, that's right, how did you know?

G: Lucky guess. Well, if there is 3/4ths of a $billion on the table every trading day, it's probable your hundred shares, if you want to make a $25,000 bet, aren't likely to nudge the price very far. So let's look to the players that might move it.

S: You mean those 872 funds?

G: Those guys, the ones that have average commitments of $90-100 million in AMZN, or about 360,000 shares. How many of them could sell out completely in an average day's trading of 3 million shares?

S: I figure only 8+ if no one else got to sell. That's about 1% of the big fund holders. So?

G: So it would take 100+ days for them all to get out. That's five months of market days. From what I know about big money managers, exit liquidity times of five months are intolerable for any "active" investment. They didn't get control of all that capital by being stupid. They must be prepared to be "long-term, core-investment" holders in AMZN.

S: Well they would have to believe that earnings per share could triple, just to get that multiple down to 33 times or at least quadruple to get it to a 25 times level. And that 100+ P/E is based on year-end 2013 EPS, estimated by 40 Wall Street analysts. Could they all be wrong by a factor of four? Only a year away?

G: Probably not, since those analysts are survivors of one of the worst Wall Street employment cutbacks most of us old-timers can remember. But it might help to think about what kind of earnings growth beyond the next year could justify current prices. That's what a PEG ratio tries to do. The usual notion is that a P/E ratio equal to its annual rate of earnings growth is justified, even attractive, if they are about the same, given five years of that growth. A stock with a P/E of 12, growing at 12% a year would have a PEG ratio of 1.0.

S: Doesn't that make Apple (NASDAQ:AAPL), with a 12 P/E and a +25% growth rate cheap?

G: Maybe, but stay focused on your original problem. What kind of growth would it take to bring AMZN down to a reasonable PEG ratio? If a 25 P/E is the target, and it takes 4 times the E being used in the P/E, then (1+400%)^(1/5) -1 tells what is needed, or about 38% a year. The resulting PEG ratio of 25/38 = .65, just about where AAPL is now.

S: Wow! Thirty-eight percent sounds like a lot, half again as much as AAPL. Can they do it?

G: Some influential folks apparently think so, or the stock wouldn't be priced where it is.

S: You mean those 872 funds? But what if they change their minds?

G: Then there's trouble, T - R - O - U - B - L - E, right here in "River City." Remember that 5-month exit problem?

S: How can I tell if they start to think differently? -- Or, instead, are remaining convinced?

G: Well I have a friend who watches the market pros that help those funds adjust their portfolio holdings. They talk with the portfolio managers at many of the funds dozens of times a day. Often, in order to buy or sell in the million-dollar trades they need to make, the pros have to put their firm's capital at risk, in order to complete the "fill" of the fund client's order. With that dough on the table, the pros are very alert to changing client convictions.

S: Will your friend tip you off if he sees trouble?

G: Please use a different term - that word "tip" has some unpleasant legal connotations. And I don't even need to talk with my friend, because he publishes daily what the pros think their clients are likely to do with stock prices in the future. He learns that from the way the market pros protect the firm capital that they have to put at risk, stock by stock, day in and day out.

S: Say, that's pretty neat. Are they getting worried about AMZN? What about AAPL?

G: I subscribe to some of his services, and I can show you, because you're part of the family. But often my friend makes important information and ideas available for free on that internet investment site "Seeking Alpha." Here are the recent trends in what the market pros - and their big fund clients - are expecting for near-future price possibilities in each of those stocks. The vertical lines show the range of prices the pros are willing to pay for price insurance to protect their at-risk capital.

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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. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Stocks: AAPL, AMZN