The 1998-2000 time period should be our best friend for helping us understand the important connection between price and value. Coca-Cola stock, which has grown earnings per share by 7.2% and paid out 2.8% per share in dividends during the past twenty years, has not delivered 10% annual returns but instead has only delivered 4.8% annual returns because the P/E ratio was over 50 at the start of the period. On the other hand, Starbucks stock traded at 30x earnings in 1995 and has delivered 21.2% annual returns since then.
From a margin of safety perspective, there is a list of risk inherent in paying over 30x earnings for an investment in any company because it means that you need to achieve 15-25% annual growth to achieve exceptional returns. The main problem is that, if the growth does not materialize, the P/E ratio slides back down to the 15-20x earnings range on the stock and a whole lot of paper wealth is deservedly evaporated.
These conflicting possibilities are on my mind as I look at the valuation of Nike stock, which now trades at over $100 per share. Everyone knows how great Nike is with its ten-year track record of 11% annual earnings per share growth and five-year track record of 14.5% annual earnings per share growth. The catch is that the stock is only earning $2.69 per share in profits (though arguably the underlying earnings power of the apparel firm is something like $3.00 per share because it earns its profits in dozens of currencies which are translated back to U.S. dollars). In any event, the stock is now valued at 33x its earnings power or 37x earnings.
That is the highest P/E ratio for the stock at any point in the past forty years.
To help figure out what type of future returns investors in Nike should expect, I’ll prepare two separate forecasts. For one, let’s assume that the next decade matches the past decade and the company grows profits by 11% annualized. If Nike does so, profits per share should be around $8.50 per share a decade from now.
Now, let’s assume that Nike is going to be a beneficiary of the direct-to-consumer movement where the middleman is cut out due to the rise of Nike stores and direct shipping from the manufacturer, and let’s assume the 14% annual earnings per share growth rate continues for the next decade. If true, Nike should be earning $11 per share a decade from now.
Next, let’s assume that if Nike grows at 11% indefinitely, the P/E valuation of the stock is 22x earnings. And if it continues to grow at 14%, it will trade at 25x earnings. That implies a stock price between $187 and $250 a decade from now. That is capital appreciation of 6.46% to 9.60%, and assuming the dividend rate continues at the same pace, total returns in the 7.5% to 10.5% range.
Of course, an investor also needs to keep in mind the possibility of reasonable downsides. During the “worst” ten-year stretch in its corporate history, Nike grew profits at 8.5% annualized. If that growth rate were to occur over the next decade, Nike would only be earning $6.75 per share a decade from now. Worse, the P/E ratio contracts right along with growth, and investors might only be willing to pay 17x earnings for the stock. That would suggest a stock price of $115 a decade from now. That is 1.5% capital growth, maybe 2.5% annual returns with dividends thrown in.
From a risk-adjusted perspective, Nike is not a great investment right now. If it were to grow at 8.5% annualized for the next decade, there is a fair chance you might only be looking at 2.5% annual returns. To capture 10%, you need 14% earnings per share growth or greater sustained over a decade. That is high amount of growth that an investor “needs” to have in order to capture strong performance.
The lesson for me is that overvaluation comes in shades. You hear a lot of hand-wringing from investors when a P/E ratio crosses 20x earnings. That is often for good reason, but for a great company with above-average prospects, the dangers don’t really start to manifest until you cross the 25x earnings threshold. At that point, the terms of the investment become “Grow at 12% or greater or I will suffer mediocre compounding.” I’m not saying that Nike will not be a double-digit compounder over the next decade, but if it does, it will require 14% or greater earnings per share growth. That type of hurdle is placed too high for my taste.
Heck, it was only two years ago that Nike traded at $50 per share. Guess what, it was earning $2.51 per share then. Profits have technically declined a smidge to $2.49 over the period of its rise to $100, and even if you give Nike the benefit of an underlying economic reality analysis (which you should), we are still talking about 100% price growth during a period of 20% earnings growth. Great things do not come to those who begin their journey at that point.
There is going to be a hard lesson on the importance of valuation for investors over the next decade if Nike grows its profits at 8-11%. When you see that type of growth from a company you own, you expect your own results to match the company’s performance. Instead, those investors will see 2-6% annual returns because the price of the stock is too high right now at $100 per share.
Nike is a great company, but valuation at the time you initiate your investment is the foundation for all future calculations of your results. As Benjamin Graham said in Security Analysis, “The price is an integral part of every complete judgment relating to securities. In the field of common stocks, the danger of paying the wrong price is almost as great as that of buying the wrong issue. The new-era theory of investment left price out of the reckoning, and this omission was productive of most disastrous consequences.” Here we go again.