The Fallacy of Earnings Estimates

By MoneyShow.com | July 01, 2011 AAA

When you're looking for growth, sometimes value can get in the way, notes Timothy Lutts of Cabot Wealth Advisory.

Last week, a doctor from Long Island City, NY asked, "Is there a Web site where I can find the earnings estimate for the next year of a certain company? I read somewhere that the fair price of a stock equals next year's earnings estimate times 20. I would certainly appreciate your help."

I told the good doctor he could find a decent free screener by searching the Internet. But then I told him why it probably wasn't a very good idea, and now I'll tell you, too.

There are many financial yardsticks by which stocks can be evaluated, and the one mentioned can be helpful if you're comparing companies that are roughly equivalent—in the same sector, are the same size, have the same profit margins and the same growth rates.

But it's rare to compare two companies that are so similar—which means that most of the time, a blunt measurement like that has little value. And even within industries, the differences typically outweigh the similarities.

Consider three companies in the sports-apparel business.

Nike (NKE) is well known. The 43-year-old company—which started out in the sneaker business—has $20 billion in sales and a healthy 10.3% after-tax profit margin.

But the company's best growth days are over. In the latest quarter, its managers grew earnings at a 7% rate; for the full year, analysts are expecting earnings growth of 12%.

UnderArmour (UA), which started out in the "performance underwear" business, is less well known. The company is only 16 years old.

But its revenues recently topped the $1 billion level, and it's growing substantially faster than Nike.

Finally, there's Lululemon (LULU), which started out in the yoga clothing business just 13 years ago. Lululemon, which is based in Vancouver, has $760 million in annual sales.

Now, if all these companies traded at a multiple of 20 times next year's earnings, it would be an easy choice to buy the fastest grower, Lululemon.

But the market's not stupid. Expecting to find that situation would be like expecting a butcher to price ground chuck the same as filet mignon.

So what the market does today is price Nike at 17 times next year's earnings; UnderArmour at 43 times next year's earnings, and Lululemon at 49 times next year's earnings.

Nike is cheaper on that basis, and the main reason is that it's growing more slowly. But is it cheap enough?

What matters is the action of the chart, the likelihood that the business will keep growing at a good speed, and the likelihood that more investors will become buyers as they develop positive opinions about the company.

With Nike, that's not happening. Investors are slowly leaving the stock, as they note that companies like UnderArmour and Lululemon are eating into its market share.

Two years ago, more than 2,200 institutions owned shares of NKE. Today, the number is below 1,800.

At the same time, the number of institutions owning UA has increased from 325 to over 400, and the number of institutions owning LULU has increased from 244 to over 300. The trends for these companies and their stocks are positive, and there's a lot of upside potential for both.

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