Fortinet Is Priced For Perfection

Summary

• Fortinet is priced for perfection. Stocks rarely achieve perfection.
• Investors shouldn't pay so handsomely for that uncertain growth.
• With a 1y forward P/E of ~30.51, Fortinet has a price-implied one-year earnings growth expectation of 918%. I think that is significantly over-optimistic.
• Fortinet doesn't beat the risk-free rate. At the moment, the earnings yield for Fortinet is 0.36%. 36 basis points, vs. the ~222 basis points provided by a two-year t-bill.

Fortinet (NASDAQ:FTNT) is a threat management and network security solutions provider. In some ways, it has done well over the past decade, delivering 500% price growth and nearly the same amount of revenue growth over the same period.

It's also significantly overpriced on a price-to-earnings basis and priced optimistically when I look at its forward P/E. This suggests that investors are paying handsomely for Fortinet's uncertain returns. I don't believe this offers investors with sufficient risk-reward. As investors - in my opinion - the preservation of capital should be our biggest concern. The best way to do that is to avoid investing in overvalued companies like Fortinet that may be priced for perfection.

Dilution

As Investopedia writes in its excellent article on dilution:

Dilution can drastically impact the value of your portfolio. Adjustments to earnings per share and ratios must be made to a company's valuation when dilution occurs. Investors should look out for signals of a potential share dilution and understand how their investment or portfolio's value may be affected.

As my readers by now know better than anything, when a company issues additional shares, an existing investor's proportional ownership in that company is reduced.

Over the past five years alone, Fortinet has diluted its shares by 5.88%.

FTNT Average Diluted Shares Outstanding (Annual) data by YCharts

To demonstrate the impact dilution may have on ownership stake, let's go back to our thought experiment, and say you buy 100 shares of Fortinet today at ~$50.46, when Fortinet has 168.02m shares outstanding.

Source: Author's Work

Let's say, over the next five years, Fortinet doubles its revenue; and, let's say, that because Fortinet investors love to reward revenue, the stock price reflects that. Let's also assume that, during that time, Fortinet has issued 6% more shares (as per the previous five years), so now there are 45.22m shares outstanding.

Source: Author's Work

A valuation increase doesn't guarantee a price increase; we're rewarded on a per share basis. Revenue per share is $16.82, diluted, instead of $17.80, undiluted. Instead of your ownership stake being worth over $10k, undiluted, it's only worth $9.5k, diluted. Because of dilution, your return is muted.

Obviously, these aren't huge double or triple digit dilution numbers over this five year period. I didn't cherry pick the data; the actual percentage going forward might be higher or lower. But it is not the only risk that investors face. Dilution is one more risk to consider, in addition to business risk, market risk, opportunity risk, inflationary risk, legislative risk, and so on. With so many other risks facing our investments, one thing investors don't need is the risk of the company diluting our ownership stake, too.

I believe the biggest risk facing investors, however, is its valuation risk.

Valuation

Even if we're talking about the greatest company in the world, if we pay too much for it, our return may be muted. As investors, we don't want to overpay significantly for a value that may not be realized.

Fortinet currently trades at a price-to-earnings multiple of 280 and a price-to-sales multiple of over 35, which means that investors are paying a significant premium for Fortinet. As we know, research links high P/Es to lower returns and lower price appreciation in the following decade.

To make matters worse, with a 1y forward P/E of ~30.51, Fortinet has a price-implied one-year earnings growth expectation of 918%. I think that is significantly over-optimistic based on Fortinet's historical performance. As the chart below shows, its earnings are failing to increase in tandem.

FTNT Revenue (NYSE:TTM) data by YCharts

Worse, of course, is that investors are paying a premium for those earnings. And investors shouldn't overpay for uncertain earnings growth.

This kind of earnings premium represents too much risk for investors. The preservation of capital is, in my opinion, our biggest priority as investors due to the simple math of it all. If you lose 50% of your investment, you have to make 100% back - not just 50% - just to break even. This table outlines the brutal reality of losing capital:

Source: Investopedia

The best way to protect ourselves from loss, I think, is to limit downside risk by avoiding overpriced companies such as Fortinet.

Conclusion

The point is this. Even granting charitable revenue growth assumptions, as I discussed above, investors should be wary due to Fortinet's dilutive history. Even assuming amazing five years of revenue growth, an investor's reward may very well be muted, if it continues diluting its shareholder base. The situation is even worse when we consider its poor earnings history and price-implied one-year earnings growth expectation of 918%. With an earnings growth assumption that high, I believe Fortinet is priced for perfection it may not achieve--and investors shouldn't pay so handsomely for that uncertain growth.

At the moment, the earnings yield for Fortinet is 0.36%. Compare 36 basis points with the ~222 basis points provided by a two-year t-bill. With an earnings yield 186 basis points less than the risk-free rate, in my opinion, it's not worth the excess risk of its shares.

Analyst’s Disclosure: I/we 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.