Growth stocks have killed value stocks lately, led in large part by four stocks. Let’s make the following arbitrary assumptions in order to have fun with the group of stocks know as F.A.N.G. (Facebook, Amazon, Netflix, and Google).
- That each company’s market cap grows by 7% per year for the next 10 years (roughly the market’s historical growth rate). 7% for 10 years leads to a doubling of market cap.
- That in 10 years, they each trade for 21.9X trailing 12-month earnings, which is the current multiple on the S&P 500
Obviously, none of this will happen, but that shouldn’t stop a little fun.
Here, in the final column, are the annual earnings growth rates that would be required to satisfy our assumptions.
Let’s take Amazon as the best example. It’s trailing 1-year earnings as of 10/31/2015 were $328MM. Its market cap was $293B. So if it doubles in the next ten years, to nearly $600B in market cap, and trades at 21.9x earnings, that means it will have to grow its earnings at 55% PER YEAR for 10 years. That is possible but highly improbable. I looked back to 1973 and found that a small percentage of companies (0.28% of them) did grow earnings at that rate for 10 years (many off of a much smaller base than Amazon).
Michael Mauboussin wrote a great Chapter on what he calls the inside view versus the outside view. I recommend the whole chapter.
In our case, the inside view is trying to explain why Amazon in particular can achieve this amazing growth rate, which would go something like this: Amazon is my favorite company, it is doing things no one else can or has. AWS is amazing, and is a higher margin business. Slight upticks in margin would significantly grow earnings.
The outside view, by contrast, is the historical base rate (percentage chance) of ALL companies hitting that type of growth rate over ten years. Again, a fraction of 1% of companies have been able to achieve this rate.
The inside view is always more seductive, but the outside view is more sobering and usually more useful.
Will Amazon be the next company to grow that fast? Could be. But based on the outside view, the odds are about 9 times worse than hitting a random number in roulette.