100 Times Forward Earnings? Get Real, Folks
In analyzing the pros and cons of certain investments, YCharts often finds itself repeating a standard warning: that shares trading at high valuations are particularly vulnerable to hard falls, even if the underlying business remains strong. A couple of unfortunate cases this year help illustrate the phenomena. Consider lululemon athletica (LULU) and Rackspace Hosting (RAX), two stocks in which shareholders found themselves right about the companies’ ability to produce double-digit sales growth, but disappointed in the investments regardless.
Analysts remain confident that both companies will continue to grow at stellar rates this year and next. Consensus estimates call for lululemon revenue to rise 22% in the current fiscal year and 21% the next. Rackspace is expected to add 17% in sales this year and $16% the following year. But both shares experienced 25% drops at points this year on less-than-catastrophic news.
Lululemon shares got hit in March when it was forced to recall one of its popular lines of yoga pants because they were too sheer. The share price took another fall a few months later when it announced quarterly earnings and revenues that beat market forecasts, but added that its CEO was stepping down.
Rackspace, chief competitor to Amazon.com (AMZN) for cloud computing services, got knocked around in May for reporting a 20% first quarter revenue gain instead of the 22% gain analysts expected. The losses deepened when the company admitted that current quarter revenue might come rise as little as 10% over the previous year period when analysts had forecast a 14% gain.
The culprit here was not so much the actual news, but rather the questionable share price valuations before the announcements. Rackspace shares were trading at nearly 100 times forward earnings at the beginning of this year, while lululemon’s forward price to earnings ratio topped 40. Their forward price to sales ratios were hovering around 8.
Numbers like that are very difficult to justify with conventional math. Those levels imply a more general expectation of very high growth, and any perceived disruption to the trend tends to make investors question those expectations.
For the record, there are plenty of investment analysts who believe these shares are still overpriced, despite their continued faith the companies’ growth. Hold recommendations well exceed buys on lululemon shares, and at least one analyst still brands them a sell. Although Rackspace has gained a couple of new buy ratings in recent weeks, its shares still gets more holds and a couple of sell ratings.
Dee Gill, a senior contributing editor at YCharts, is a former foreign correspondent for AP-Dow Jones News in London, where she covered the U.K. equities market and economic indicators. She has written for The New York Times, The Wall Street Journal, The Economist and Time magazine. She can be reached at email@example.com. Read the RIABiz profile of YCharts. You can also request a demonstration of YCharts Platinum.