When the consensus is wrong
The basic idea behind growth stock investing is to find a company where earnings will be growing faster than the consensus expects for longer than the consensus expects.
An example: Let’s assume a stock is trading at $20 a share. It had earnings of $1/share last year and is expected to grow by 15% each of the next few years. This means that, on consensus expectations, it is trading on 20x historic earnings, 17.4x this year’s earnings, and 15.1x next year’s earnings. As a crude rule of thumb, one might say that fair value for a stock is to have the price earnings ratio equal to the growth rate on next year’s earnings. On that measure, the stock is fairly valued.
Let’s say the true earnings growth rate is 40%. That would mean that our stock is trading at 14x this year’s earnings and 10x next year’s. That’s about a quarter of what our rule of thumb would imply. Apple is a recent instance of this phenomenon.
How does the market adjust its expectations upward? Continue reading