Forum Archive Index - March 2001

["Peter Maiden" <pmaiden@xtra.co.nz>]

Some talk about investing in growth stocks etc earlier today. Maybe these thoughts may be interesting.

Firstly a disclosure - this has been extracted from a note I wrote a few months ago to somebody who was worried about what to do with an investment in Baycorp he controlled. I don't have any Baycorp shares myself but thought that readers of this forum might appreciate my thoughts. Note that when I wrote this the price was $12.50 odd - I see that it is down below $11.00 today.

Some research I came across a while ago showed that there is no correlation between a company's expected long term earnngs growth (as per the company's share price earnings ratio) and the long term price change in the company's share. The study was conducted on the FTSE 100 over a ten year period in the nineties and concluded that the correlation between PE ratios and subsequent share performance is zero - stocks with low PEs do no better or worse than stocks with high PEs. In other words PEs are useless as an indicator of future earnings growth.

Isn't it a fallacy then to believe that to make money from shares you must invest where the growth is. High earnings growth does not necessary mean high long-term investment returns.

However one shouldn't ignore earnings growth as over extended periods of time a company's share price cannot grow faster than earnings. At least in theory because if it did the PE and market capitalisation would approach infinity.

What the study did show was that the market does a poor job of forecasting long term earnings.

To put a Baycorp slant on this.

Baycorp has a sensational business model and a proven record of strong earnings growth. The business model appears to be able to sustain strong earnings growth well into the future.

Thinking it through anything that is anticipated should not affect stock prices. Is Baycorp meeting anticipated earnings growth? In spite of achieving consistently high earnings over many years ( a no mean feat for a New Zealand company) it does appear that Baycorp are not meeting anticipated returns..

In 1997 EPS increased by 28%, in 1998 by 23%, in 1999 by 21%, in 2000 by12% and in 2001 a projected 14%. Reported 20% plus increases in actual earnings have been diluted by the issue of shares to fund growth.

The growth in EPS is slowing down - and the numbers do not support a PE of 50.

Over time there has to be to be an adjustment to the Baycorp share price to a lower PE which better reflects actual EPS growth. This has dire consequence on the Baycorp share price.

One way of looking at it is to assume that the share price remains at $12.00. Even if 20% EPS growth is maintained into the future it will take into 2006 for the $12.00 to reflect a PE of just over 20. At 15% EPS growth it will take until 2008 before the price reflects a PE of 20.

The other way of looking at it is to assess what the current price should be based on a different PE multiple. This year the EPS projection is 22.5 cents (with total earnings up 20% on last year). A PE of 20 then gives a share price of $4.56. The share price would then increase at the growth in earnings rate if a PE of 20 was maintained.

I have used a PE of 20 because that is the growth rate I have used in calculations. Some might say that Baycorp should trade at a premium to this. However it is the dimensions of the variance to the current price I am trying to demonstrate,

Whatever happens this is one company that will continue to experience strong earnings growth but it is very unlikely that investors will benefit from long term gains in Baycorp's share price. Even a possibility of a takeover is unlikely because of the inherent amount of goodwill that any acquirer would need to take on - a market cap of $1B for a company with $70M revenues and $20M earnings does not make a takeover likely.

And so on......to a recommendation

Cheers

Peter