How Intuitive Surgical Justifies Its Lofty Valuation

By James Brumley | December 30, 2011 AAA

It's not easy to own a stock that's trading at 39 times its trailing earnings, with little hope of that changing anytime soon. In the case of Intuitive Surgical (Nasdaq:ISRG), the premium may well be worth it. (For related reading, see P/E Ratio.)

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Value Versus Growth, on Steroids
No, Intuitive Surgical certainly isn't a value stock. Competing surgical device and equipment makers like Medtronic (NYSE:MDT) and Zimmer Holdings (NYSE:ZMH) both boast much lower trailing price-to-earnings measures. The former trades at about 12 times its trailing twelve-month earnings, and the latter at around 16 times its trailing income. The industry as a whole is sitting on a P/E of 16.3.

Time to shed ISRG shares then? Were it most other industries with that kind of disparity, the answer would probably be "yes". When it comes to medical and surgical equipment though, what seems like a ridiculous valuation may be far more supported than most investors could ever imagine.

Healthy Track Record
For proof, look no further than Intuitive Surgical's five-year history. Since early 2007, the stock has gained about 390%, yet its trailing twelve-month P/E has been above 26 almost the whole time and has averaged approximately 36 for that span. The only time it dipped below the 26 mark was in early 2009, reaching 17.5 before moving back above 26.0 by the middle of the year. Yet again, the stock soared despite a valuation that would be unpalatable for most other names.

Lesson learned? "Expensive" is a relative term. More important to today's nervous shareholders though, the rather high P/E measure isn't necessarily a reason to bail out. Indeed, there may even be reason for newcomers to step in. (To learn more, read Beware False Signals From The P/E Ratio.)

How to Justify Frothy Valuations
Most stocks can't sustain valuations of more than 30 times their trailing earnings. There's an important lesson from the ones that can, however - they've proven they can innovate and grow earnings (an obvious but still-rare quality), and they've captured the hearts and minds of investors.

Take Amazon.com (Nasdaq:AMZN), for instance - another stock that has averaged an enormously high P/E reading (of above 90) for the past five years, yet it has gained around 346% during that time. The key to Amazon's unlikely stock success was a great underlying story that was more important than the lofty stock price.

The Sky's the Limit for da Vinci Robots
Though Intuitive Surgical doesn't innovate in a way that drives consumers wild - like Amazon has, or Apple (Nasdaq:AAPL) has with its iPad - it is doing so within the medical equipment world. Its da Vinci surgical robots continue to be cleared for more and more uses, with the latest one being gall bladder removal.

Actually, scratch that - the latest use the surgical robot may have is as a way of repairing NASA's satellites. The nation's space agency is looking for ways to make such repairs more cost-feasible, and at less risk to human life. For patients, investors and surgeons (even if on a subconscious level), there's just something cool about the technology good enough to fix satellites also being used to fix people. The unique technology has trumped the high price of the stock. It has for years, in fact, because there's still nothing else quite like it. The fact that the company has grown its bottom line for five straight years - tripling it in the process - doesn't hurt either. Though again, that's an extension of innovation and keeping investors impressed.

Bottom Line
So no, don't sweat what seems like a frothy price. For ISRG, it's the norm. (For related reading, see How To Use The P/E Ratio And PEG To Tell A Stock's Future or Become Your Own Stock Analyst.)

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At the time of writing, James Brumley did not own shares in any of the companies mentioned in this article.

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