Fantasy Girl - Reality Sets In - Part X
This series was started because of how I could see linear, exponential and leverage math concepts being mixed up and wrongly used in the valuation of stocks, causing periless risk to investors. Within a limited range, the PEG concepts can be used interchangeably, with marginal overall effects on calculations, but, with large growth, it is as absurd to use these concepts in valuation as it is to expect 10,000,000,000% return (part I).
Part I-V in this series looks at exponential growth for individual investment (part I & II), and then how expectional growth in one quarter that then has exponential concepts applied to it can hide a rapidly declining rate of growth, as is happening with Google (part III & IV). They had a growth rate of about 45% in Q1/06, which declined to about 20% in Q2/06, and has further declined to about 5% in Q3/06, yet the press releases of the Q2 and Q3 earnings present an increase in growth, as will Q4. The math simply says if you mix up linear and exponential concepts with large growth figures, you will show a dramatic increase in growth in Q4, even if there is ZERO growth over Q3 in Q4.
Here's a simpler look, say earning were $1, and they go up 50% in one quarter, now you have $1.50, and another 20% in the next quarter gives $1.80, and another 5% gives 1.89. Can you see that even if the next quarter is zero percent, you can still report 89% growth over a year earlier? Forty-five percent in a quarter annualizes to 320% in a year, or over 7 times the original growth, and it has added an extra 240% to the linear concept. Ten percent in a quarter annualizes to 46%, only 6% added is added for a single year, although that gets out of control when looked at for 5 years 200% linear versus 570% exponential. For Google, that 240% is hiding the death of the growth within a single year.
Using the math correctly shows that Google needs a magic fantasy for earning for Q1/07, or the PEG valuation crashes and burns. Google has about $10 billion in cash, so it has the opportunity to buy profitable businesses before then to increase earnings for Q1/07 and it still has growth potential in its overall business, but not a growth potential of 70% per year, which is the expectation of the current valuation -- an expectation as absurd as 10,000,000,000%. Can someone teach me how to short???
Part V is a much more reasonable method of valuation for high growth stocks. It takes more work, but keeps your investment far safer. But, if you want to walk the tight rope and gamble on people's greed, fear, and lack of math skills, Google's a good choice, kind of like playing chicken, you know, when the two cars are driving head-on towards each other.
Part VI-IX takes a closer look at mining stocks, in particular, mature gold stocks. In my earlier blogs, valuation comparisons of Northern Orion to Goldcorp I found it utterly shocking that the price elasticity of gold bullion to the actual stock was 10 times better for the bullion, and with the stock, you no longer own the gold to boot with the mine, yet there's a buying spree on mature gold stocks. I did not know what I would find with an indepth analysis, but that greater than 10-fold difference in price elasticity to market cap is a very, very, very bad thing for gold stocks, and should set off screaming alarm bells for investors. I found relative price elasticites varying from about 1/4 to 1/20th for mature gold stocks compared to the bullion. Can someone teach me how to short???
Some of my findings were utterly counter intuitive, with what I would have expected, but with further thinking about it, makes complete sense.
It was completely counter intuitive that a high cost producer could have been a better investment. But when you consider their measly earnings would have held the share price back, there was tons of room for leverage of earnings.
And I did not expect to find the enormous leverage increase in earnings for gold stocks due to other metals, for example, copper, $0.90 to $3.80, 420%, and with future contacts, an average quarterly price of $4.44 was reached, a 500% increase. Gold has to get to $1500 to match this leverage, and the decline in realised copper prices is hitting earnings. At $3.20 for copper, Goldcorp has to see gold rise $50-100/oz just to offset this loss of earnings.
There is no question that the exceptional performance due to the leverage of earnings has led to a static acceptability of valuation for brokers and investors, ie, P/E ratio of about 25 for gold stocks. But an examination of how rapidly the leverage of earnings declines with increasing gold price, along with the increasing costs demands a re-evaluation of what is a reasonable expectation for the future of mature gold stocks.
There is nothing in the math to support that earnings will continue to show stellar increases, indeed, with cost increases due to aging mines and replacement costs gold prices need to increase to maintain earnings, never mind increase them.
The 2009 year end earnings per share for Goldcrop is estimated at $1.03 by the guy writing the report linked below, which at the bubble valuation P/E of 25 gives a three year target of $25.75. How he came up with a $40 target is beyond me. His $1.03 estimate is 3 years away, discounted by 10% per year gives a valuation today of $19. But, using a bubble valuation P/E of 25 in itself is crazy because mines, in particularly gold mines, are grossly depreciating assets, like a car. A target P/E of 12 is generous for a mine, and that gives a 3 year price of $12.36, discounted by 10% per year gives a today price of $9.29.
Another perspective, at $40/share, market cap would be $28 billion for Goldcorp. At 3.5 million ounces of gold, their highest production projection, say gold doubles to $1300, well $650*3.5 million, that's an extra $2.3 billion in earnings, after taxes you have about $1.4-1.5 billion. Say 100% of that goes to earnings. That increase earnings by about $2/share, for a total of about $3/share. At $40/share, that's 6% earnings and not owning the gold compared to 100% increase and owning the gold.
Junior gold stocks are a different story, but any mature gold stock demands a very careful analysis of where future cash flow would come from, and not a blind acceptance of P/E ratios of 25. It is time to take the blinkers off.
https://research-ca.bmocapitalmarkets.com/documents/BD5A862F-EAFB-463A-8A19-2EB5D93032A6.PDF