Published: October 25, 2010
I spend the vast
majority of my time hunting down securities I believe are
significantly undervalued and investigating those in great
detail I believe have considerable upside potential. However,
it's also a valuable exercise to spend some time on the opposite
end of the spectrum and analyze what I find to be unappealing or
speculative investments that offer horrible risk/reward
Fast-growing companies are prime real estate for uncovering
investments that can head south in a big hurry. Growth in itself
is an extremely important metric in finding appealing
investments. As such, it is the valuation that can end up
causing big headaches for investors in rapidly-growing firms.
Momentum is another issue. A significant demographic of
investors includes individuals and institutions that trade with
black-box-type algorithm models, screening for and investing in
companies experiencing acceleration in sales and earnings, or
have made a habit of beating analyst expectations for a number
of quarters in a row. The problem is, this class heads for the
hills at the first sign of trouble.
VMware (NYSE: VMW) meets many of the criteria that can
make for a bad investment. For starters, it operates in the very
rapidly growing market for virtualization software that allows
for cloud computing. It serves the burgeoning market for
software as a service, or Saas, for short. It's about as hot as
any sub-industry in tech and is expected to remain so for the
VMware is growing like
gangbusters right now. It recently announced third quarter
results that saw sales jump +46% to $714 million and recurring
earnings catapult +63% higher to $0.39 per share. Earnings beat
analyst projections, and have either met or beat consensus
targets for at least seven quarters in a row now. That is music
to the ears of the momentum crowd -- for now that is.
As for the valuation, you guessed it: Analysts currently project
full-year earnings of $1.39 per share. The stock price, which is
hovering in excess of $70 per share, means the shares carry a
P/E of almost 53. That is nose-bleed territory, reminiscent
of the dot-com days when many leading tech companies were
trading at very lofty multiples.
The company is expected to grow sales close to +40% for the full
free cash flow generation is decent, as VMware is expected
to report more than $1 billion, or more than $2.56 in free cash
flow for the year. However, that's still an excessive multiple
of almost 29.
Action to Take ---> What
will likely trip up future gains for VMware's stock is the very
high growth that the company must post going forward. The higher
the multiples of earnings and cash flow, the higher a firm must
grow to justify where the stock is trading.
Companies are valued by discounting their expected future cash
flow back to the present at a certain discount rate. The higher
the stock price, the higher growth has to be to justify the
price. It's nice to find a company that is posting impressive
growth in this market, but you should stay away from those that
have been bid up excessively. Growth at any price is not a valid
strategy in this market.
By my estimations, VMware must grow its cash flow by more than
+30% each year for the next five years. If it does that, then
the stock is fairly valued. In total, this means cash flow must
more than triple to more than $9.50 by 2016. To do this, sales
must grow at a similar clip.
It's definitely achievable, but I see a higher likelihood that
VMware falls short of these aggressive expectations, which means
its current shareholder base will exit the stock just as rapidly
as it entered. Again, the company's operations are growing
impressively and is appealing in this regard. But this
represents a case of a good company -- but a bad stock. The
valuation for VMware is just too high. In fact, it's about as
high as I can find in the market, which makes this one of the
most speculative investments out there today.
-- Ryan Fuhrmann