When Growth Stops

Investors sometimes figure that if they can foresee a certain amount of growth in a company's earnings per share then it should be reasonable to anticipate a similar amount of growth in the company's share price.

Indeed, this simple approach is effectively the standard approach for many US broker analysts, who often set target prices for a company’s stock by simply multiplying their forecast for earnings per share in a couple of years' time by the company’s current (or recent average) price to earnings multiple. Regardless of how expensively priced a stock is, this approach will invariably generate a target price above the current share price if the analyst is expecting growth in earnings per share.

Investors with a longer-term focus will often follow a conceptually similar approach, by making a prediction about what sort of earnings growth they expect a company to deliver over (say) the next decade and then estimating what they think the company will be worth in a decade’s time by multiplying their expectation of its future earnings by an earnings multiple that is not too different from how the market currently values the company.

Often, investors following this sort of approach will freely acknowledge that they expect the company they’re investing in to be mature (i.e. not growing any faster than the broader economy) in a decade’s time. But they will nonetheless like the company as an investment, because they are confident of their ability to predict a decade of super-normal growth, as well as being confident that they will ultimately be able to sell the investment on a high earnings multiple (despite the fact that growth may be slowing when they do).  

The shortcoming of these approaches is that earnings multiples can and do change significantly over time, and earnings multiples tend to reflect investors’ expectation for future growth. If a company grows to the point where investors can see that it has little potential for further earnings growth, then its price to earnings multiple is likely to decline to reflect the diminished future growth opportunity.

Although there have been few examples over the past decade, the first decade of this millennium saw many examples of companies that tripled their earnings, yet ended the decade with a lower share price than they started with. (The graph below shows a rare example from the last decade of a company – AMC Networks – that has seen a fall in share price despite significant earnings growth).

 

The fact that we have seen few companies experiencing some dramatic declines in earnings multiples during the rising market of the past decade should not comfort growth investors into thinking that share prices will almost always follow rising earnings.  In fact, the unusually wide dispersion within the sharemarket between earnings multiples of different companies means that from today’s starting point there is a far greater likelihood that declines in earnings multiples could offset earnings growth for companies that are faced with an imminent slowdown in earnings growth.

Indeed, in the past month there have been several examples of companies that have reported a further quarter of earnings growth but have experienced a significant drop in their share price because there were trends and comments in the earnings releases that made investors worry about whether these companies were “running out of growth”. These examples should serve as a reminder to growth-focussed investors that it is important not only to think about how much a company may grow, but also to consider how the market will value that company once the growth slows down.

One prominent example was Netflix, which released its December quarter earnings on the 20^th of January. The numbers that Netflix reported still involved a lot of growth – revenues were 16% higher in the December 2021 quarter than they’d been in December 2020 quarter – but the quarterly growth in subscribers was weaker than analysts had expected, and the company’s guidance for 2022 implied slower growth than investors and analysts had hoped for. Netflix’s share price has fallen more than 20% since it released its earnings result.

Another example was Meta (which owns Facebook and Instagram) which released its earnings on the 2^nd of February (the day before I write this column). Meta’s revenues were 19.9% stronger in the December quarter of 2021 than the December quarter of 2020, but these numbers were disappointing compared to Google’s 32.5% growth in advertising revenue (released the day before), and there was no growth during the quarter in the number of people using Facebook, nor in the time they spent each day on Facebook. Meta’s management were cautious in their comments about the outlook, pointing to a number of headwinds they faced from competition and regulation. The apparent slowing in Facebook’s growth outlook caused Meta’s share price to fall -26.4% over the day following its earnings announcement. 

The share market’s valuation of Meta in response to this slowing outlook should be particularly concerning for growth investors, as it sets a precedent as to how low a “big tech” company’s valuation may go when it seems to be running out of growth. Meta’s market capitalisation has fallen to US$647 billion, which implies a valuation of US$614 for all its businesses when we strip out its balance sheet cash. If we assume that Mark Zuckerberg’s nascent loss-making metaverse-orientated “Reality Labs” business has a net zero value, this implies that the Facebook and Instagram businesses are being valued at just 10.8 times pre-tax operating profits.

This valuation multiple should represent a scary potential end-point to anyone who is planning on holding other growth businesses until their growth runs out, as it is a much lower multiple than these businesses are currently trading at.

Take Amazon as an example. As I write this article, Amazon’s share price is up +14% in after-hours trading on the back of an earnings result that wasn’t as bad as the market feared. Based on this after-hours share price, Amazon’s business is being valued by the market at US$ 1.634 trillion, represent 65.7 times annual pre-tax operating profits. There seems to be a lot of potential downside to Amazon’s share price if the market concludes that it’s earnings are slowing in a way that is comparable to Meta’s.

Indeed, it is not a stretch to think that investors may start to grow concerned about a slow-down in Amazon’s growth. Overall, Amazon’s revenues showed just 9.4% annual growth in the latest quarter, slower than either Meta or Netflix. However, the aggregate growth rate is an average of two quite different parts of Amazon’s business. Amazon’s “traditional” online retailing business has been slowing dramatically, recording just 6% revenue growth in the December quarter. This business was unprofitable in the December quarter, and with a diminishing prospect that this business will grow its way into profitability, Amazon is increasing the price of its Prime membership subscription fees (a decision that will undoubtedly enhance near-term profitability while hurting long-term growth prospects).

By contrast. Amazon’s “AWS” web services business continues to show strong (and profitable) growth, with revenues up 40% (after adjustment for foreign exchange effects) on the comparable quarter of the previous year. Arguably, most of the value of Amazon now sits in the AWS business, but there is little room for error when a US$ 1.634 trillion valuation is being supported mainly by a business that generates just US$62 billion of annual revenues.