In the fall I was writing my blog over on Stockhouse and I wrote this 10 part series which I titled Fantasy Girl and a subtitle for each post. Half the posts were taking detailed look at why Google's earnings would not keep up, as in the news story Google's Profit Falls Short, Shares Drop. The other half were looking at Goldcorp and the serious valuation problems with that one for investors. Those parts I worked on polishing up further and turned it into my post, How I Discovered the Gold Bubble.
For the Google related part of the series I intended my posts to show how when growth rates are unreasonable large applying that PEG dogma is nonsense by starting with an absurd rate of interest and hoped people would make the connected that their expectations from Google were also absurd.
I like Google's products and services and use the all the time, however, when too many people get on a boat it sinks. Here's my original analysis of Google from November 2006.
Fantasy Girl - Up 10,000,000,000 % Part I
Have you ever had a day where you could say you were up 10,000,000,000%?
Are you sure?
Just what kind of daily percent would you have to make each trading day to make 10,000,000,000% in a year?
Compounding interest is a wonderful thing. I do this math thing where my spreadsheet calculates my percent change for the day, and my annualize change if I did that percent each of the 240 trading days of the year.
The formula if you let D be your day's earnings, O be your day's open is:
Annualized rate of return = (1 + D/O)^240 - 1
The D/O gives you your percent increase for the day, and taking it to the power of 240 compounds it much the same way you might to a simply compounding interest calculation for 10 years.
So, what percent?
Well, I found out yesterday, and wow, what a lesson on compounding interest. 10 billion percent it said, and I went to correct my error, only there wasn't an error. At that point my portfolio was up 8%, and wow, the annualized rate of return if you could do that everyday is 10 billion percent! And a different stock, with a small holding, went up, so I changed it, and wow, up 13 billion %, and up more, and then 33 billion %.
But wait, that's not a lot of extra dollars causing that jump. Huh? I looked at the percents, 8.1% gets you 13 billion, and 8.5% gets you 33 billion, and well, 10.1% gets you over a trillion %.
In absolute terms, the increases are small compared to compounding effects. By comparison, to go from 0%, to 0.1%, the same absolute difference, as 8% to 8.1% the annualized rate goes from zero to 27%, a small percentage difference compared to from 10 billion to 13 billion %.
And herein lies part of the problem in how we can get ourselves into enormous trouble with our portfolio when past growth rates of a company are used to project future valuation. The bigger the growth, the company experienced, ie, already had, the harder it is to ever meet that crazy expectation.
In the next few posts I'll examine the financial difference between using past growth numbers and future growth numbers, and how some of the those past growth numbers are setting investors up for financial ruin.
Fantasy Girl - 300 Billion! Part II
The main idea from the first post in the first Fantasy Girl series was that as the rate gets higher, the magnitude of the difference in compounding increases dramatically with tiny increases in the rate use. The two examples have a mere 0.1% difference in rate. Compounded rate = (1 + daily rate)^240 - 1
| Daily rate
| Compounded rate
|
A
| 8% | 10,000,000,000% |
B
| 8.1% | 13,000,000,000% |
B minus A
| 0.1% | 3,000,000,000% |
C
| 0.0% | 0% |
D
| 0.1% | 27% |
D minus C
| 0.1%
| 27%
|
The tiny increase in rate in these two examples is 0.1%, but the absolute difference becomes unimaginable as the rate gets absurd.
But, what would happen if you did that 0.1% per trading day for say, 12 years?
| Year | Total interest |
| 0 | 0% |
1
| 27%
|
2
| 62%
|
3
| 105%
|
4
| 161%
|
5
| 232%
|
6
| 322%
|
7
| 436%
|
8
| 581%
|
9
| 766%
|
10
| 1001%
|
11
| 1299%
|
12
| 1679%
|
Well, if you started with $10,000, in 12 years you'd have $177,88, and $167,880 of "wealth" has been created.
But, just how did that wealth get created?
There are many paths to that wealth. Some will create wealth that will be sustainable, and some could be described as lying in wait for nuclear melt down.
How about taking a look at say ... Google (GOOG), and later, a much smaller company.
Google's market cap is $153 billion dollars. Google's share price is up about 33% in two months. About $38 billion dollars of market cap.
And just what is the annualized rate of growth if you increase by 1/3rd in 3 months?
(1.33^6 -1) = 213%
Oh boy, if we keep going like this, we should see $1100/share by next summer and a market of $300 billion. What a great company... And wow, this company is everywhere, it can do anything...
But....
Part III a closer look at what Google's financials are saying...
Fantasy Girl - Googlplex 10^100^10 - Part III
Googolplex - 1 followed by a googol of zeros
Recap:
- As growth rates increase even marginally, they have exceptionally larger effect on the end numbers.
- Google has a market cap of $153 billion and its share price is up 33% in two months, creating $38 billion of market cap.
- To continue at the current growth rate, Google would be up 210% by the end of the year.
Oct 19, 2006
EXTRA, EXTRA READ ALL ABOUT IT
Google Revenues increase 70%
The PEG Ratio says that if price/earning is less than the growth rate, you've got an undervalued stock, although the Motley Fool suggests it should be 0.5 or less to be undervalued (http://www.fool.com/Pegulator/pegulator.htm). For correct use, the PEG is dependent on an expectation of 5 years of growth at the rate used for the earnings per share.
So, just what have Google's earnings per share been?
Quarter
| Earnings/ share
| 1% increase over last Quarter
| 2Annualized Quarter Growth
| 3Annual Growth to Q1/05
|
Q1 2005
| 1.29 | n/a
| n/a
| n/a
|
Q2 2005
| 1.19
| -7.8%
| -27.6%
| -27.6%
|
Q3 2005
| 1.32
| 10.9%
| 51%
| 4.7%
|
Q4 2005
| 1.22
| -5.5%
| -20%
| -7.2%
|
Q1 2006
| 1.95
| 59.8%
| 553%
| 51%
|
Q2 2006
| 2.33
| 19.5%
| 104%
| 48%
|
Q3 2006
| 2.36
| 1.2%
| 5.3%
| 41%
|
1This is a quarterly rate of return (loss). 2The rate must be taken to the 4th power to get the annualized rate. 3This is what the rate of return is if it was constant back to Q1 2005.
The headline said 70% growth, where is it in the earnings?
Seriously, time to apply the PEG ratio, using the 5 year standard that it was based on. So, being optimistic, lets say that overall annual rate of 41% will be continue over the next 5 years. Keep in mind that a 41% annual growth rate means we are looking for 1.41^5-1 = 457% over the next five years. If you don't appreciate why we are looking at 457% growth over the next 5 years, go back and read www.stockhouse.ca/blogs.asp?page=viewpost&blogID=459&postID=6959.
So P/E = $505/(2.36+2.33+1.95+1.22) = 64.2
Hmmm, 64.2 is not less than 41. 457% of sales growth over the next 5 years will not be enough. 64.2/41 = 1.56
Double hmmmm. At 1 - 1.3 the Motley fool is saying a stock is overvalued. At 1.7, it is saying short!
But, there is something even more serious to notice here, the gross rapid decline in the quarterly growth rate in 2006. The decline in that growth rate is like a nuclear melt down.
And seriously, 1.642^5-1 = 1094%. To force the PEG to be one, we need 1094% in growth of earnings over the next 5 years. And that's for the current share price to catch up to itself, without growing at this absurd rate of 450% per year. We need even more growth in real sales and real wealth if the stock continues to create market cap out of thin air.
But, given this, I predict the next headline will read an even great rate of growth. Next post I'll explain how the numbers can be used to show this, and I'll even predict when the nuclear meltdown will occur.
And even more seriously, earnings per share are 1.6% of the share price. You can do better in the bank and your money is safe.
Fantasy Girl - Googlplex^Googlplex - Part IV
Googol - 10^100
This is the 4th post in a series on valuation and growth when growth rates are big.
Recap
- Google's 2 month growth rate on share price ($380->$505) is 210% annualized.
- Correct use of PEG says earning must be expected to increase by 1094% in the next 5 years without any further increase in share price.
- Quarterly data on earnings per share show dramatic declines in growth.
Perceptions of Growth - Google's Next Quarterly Report
The last quarterly headline read "Revenue Up 70%." And the next report will probably read something like "Earnings up 90%." Remember the 3 billion percent difference in annualize return between 8 and 8.1% from part 1? Yet it didn't seem so extreme using 0% and 0.1%. A large past growth rate easily hides rapidly declining growth. Here's how.
First, we need to look at earnings per share and increases in earnings per share over the previous quarter, and the quarter one year ago.
Quarter
| Earnings/ share
| % increase over last Quarter
| % increase over Quarter 1 year earlier
| Quarter increase annualized
|
Q4 2004
| 0.71
| n/a
| n/a
| n/a
|
Q1 2005
| 1.29 | 82%
| n/a
| 997%
|
Q2 2005
| 1.19
| -7.8%
| n/a
| -28%
|
Q3 2005
| 1.32
| 10.9%
| n/a
| 51%
|
Q4 2005
| 1.22
| -5.5%
| 72%
| -20%
|
Q1 2006
| 1.95
| 59.8%
| 51%
| 552%
|
Q2 2006
| 2.33
| 19.5%
| 96%
| 104%
|
Q3 2006
| 2.36
| 1.3%
| 78%
| 5.3%
|
If you just compared Q3-06 to Q3-05, you'd see a 78% growth in earnings, and that's exceptional. But, where in the news was the headline:
Google's Growth in Q3 Earnings Decline by 94%
(1-1.3/19.5) * 100% = 94%
We are playing with exponential growth here, so it is fundamentally important to consider the exponential growth consequences.
But, lets look at how the headlines will read for Q4, based on 3 projections I got from MarketWatch, a low estimate of $2.31, a mean of $2.72, and a high of $3.13. Notice earnings in Q4 2005 were down. That's going to be great for punching the numbers to make things look good... Might even be able to get away with increasing projections to $1000 per share!
| Q4 2006 Estimate | % increase over $1.22
| % increase over $2.36
| Annualized Growth Rate
| PEG = one @ |
| 2.31 | 89% | -2.1% | -8.2%
| $795
|
| 2.72 | 123% | 15.3% | 76.5%
| $1150
|
| 3.13 | 156% | 32.6% | 209%
| $1500
|
So, there you have it, the next headline:
Q4 - Google's Earnings up 89%
And the red elephant hides in plain view. PEG wrongly used supports share prices at a low of $800 and a high of $1500, creating an additional $90 to 300 Billion in market cap, out of thin air. I need one of these money trees in my back yard.
But what of Q1 - 2007? Notice that jump from $1.22 to $1.95 between Q4 and Q1? That's going to play havoc with the numbers. MarketWatch estimates are a low of $2.10, a mean of $2.98 and a high of $3.28
| Q1 2007 Estimate | % up over $1.95
| % up over $2.31
| % up over $2.72
| % up over $3.13
| Annualized Rate Over $2.32
| Annualized Rate Over $2.72 | Annualized Rate Over $3.13
| PEG = one @
|
| $2.10 | 7.7% | -9.1% | -23%
| -33%
| -32%, | -65%
| -80%
| $73
|
| $2.98 | 53% | 29% | 9.6%
| -4.8%
| 176% | 44%
| -18%
| $550
|
| $3.28 | 68% | 42% | 20.6%
| 4.8%
| 307% | 111%
| 21%
| $725
|
There's a lot more red elephants in that chart, and the growth over the same quarter in the previous year is much smaller than what Q4 projects. I predict there's going to be a lot of pain right about here.
One more thing, that by looking at the PEG calculation between three estimates and 2 quarters and finding a share price valuation that varies by a magnitude of TWENTY ($73 vs $1500) simply says the PEG is grossly misused and is best left for Voo Doo economics.
Part V, a different kind of valuation...
Fantasy Girl - Scrooged - Part V
"But you were always a good man of business, Jacob." Ebenezer Scrooge
Recap
- Google's market cap: $153 billion, $38 billion created in past two month.
- Q4 PEG could support $800-$1500 share price, creating up to $300 billion more market cap.
- Q1/07 PEG could suggest a share price as low as $73, destroying $130 billion in market cap.
- Oops, easy come, easy go, $6 billion of market cap gone today 11/27/06.
How does your bank treat you?
Ultimately, sound investment is about a company's ability to generate earnings relative to the investment. Sure, there is tons of money to be made on greed, fear, and speculation, but that isn't realistic or fair valuation.
Your bank:
- Wants security for 6%
- Good credit rating for 10%
- Has legal recourse against you
Google, earnings per share from the last 4 quarters comes to a mere 1.6% of share price, you have no legal recourse and you are risking your savings. By banking standards, for fully secured, earnings per share needs to be in the $30/share range $7.50 per quarter at the very minimum. Currently, Google's earnings per share aren't even keeping up with the rate of inflation!
So, just how much do you expect Google to grow to reach market staturation? At some point all companies reach maturity and have limited growth prospects. Where is that for Google, and how many years?
Say the company grows to earnings of $50 per share in 10 years to reach market maturity, and at that point because Google is a big secure company, that's about where earnings will stay. This is a highly optimistic quarterly growth rate for earnings of 4.3%.
Lets examine 3 examples:
- You want 6% return on your money and you are confident Google can to it.
- For that kind of speculation, you want 10% return on your investment today.
- You think growing to earnings of $50/share is highly unlikely, and you want 15% because of the high risk you are taking because it is highly unlikely.
For $50/share earnings to be 6%, the share price would be $833.
% return wanted (r)
| (1+r)^10 | Present Value of Shares
|
| 6% | 1.79 | $465 |
| 10% | 2.59 | $321 |
| 15% | 4.04 | $206 |
So, with a low expectation of return (6%), and highly optimistic growth projections (>400%), a fair share prices would be $465. But wouldn't bonds be safer?
With a 10% expected rate of return, and a highly optimistic growth projection, $321 would be a fair share price.
And finally, if you don't think it is likely, and want 15% return because of the high risk of not making it, $206 is a fair share price.
Some created wealth is sustainable, but some is simply waiting for nuclear melt down. So Barrons called Google richly valued today.
Can we say Google Bubble?
Next a little gold dust fantasy.
www.forbes.com/2002/09/13/400fictional_5.html
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