That Five-Year Forecast Looks Great, or Does It?

Mark Hulbert
25 January 25 2004
The New York Times

ALTHOUGH the stock market is not as expensive as it was in early 2000, it has many "pockets of craziness," in the view of Josef Lakonishok, a finance professor at the University of Illinois at Urbana-Champaign.

Professor Lakonishok bases his assessment on a historical study that found that companies trading at high price-to-earnings ratios almost never grow as quickly as they need to justify their high valuations. The study, published last April in The Journal of Finance, was written by Professor Lakonishok and two other finance professors: Louis K. C. Chan, also at Illinois, and Jason J. Karceski at the University of Florida.

As part of their research, the professors checked a database of all publicly traded domestic companies for those whose earnings at any time from 1951 to 1998 grew at more than the median annual rate for five consecutive years. That may seem a modest prerequisite, since that median over those 48 years was around 6 percent. But very few companies met that condition, and those that did were rarely those that investors had valued at the high end of the spectrum. The professors concluded that very high P/E ratios were hardly ever justified.

In 2004, however, many investors evidently expect that some companies' earnings will grow much faster than 6 percent a year. To show that, it's necessary to do some math. Consider eBay, whose P/E ratio, based on earnings for the 2003 calendar year, is around 102. Assuming that eBay's stock price grows just 8 percent a year for the next five years, to $102 from its current $69.35, and that its P/E ratio in early 2009 is 40, then its earnings per share will have to grow 30 percent, annualized, for the next five years to justify its current valuation, according to Professor Lakonishok.

He says these assumptions are conservative. An 8 percent return is below the stock market's annual average over the last century. And a company's P/E ratio almost always declines as its business grows and matures. Over the long term, the market's average ratio is below 20. To the extent that eBay's ratio five years from now is lower than 40, or that its stock price grows faster than 8 percent, annualized, its earnings will have to grow even more than 30 percent a year to support its current valuation.

Professor Lakonishok has not studied eBay's business in particular, so he does not want to estimate its earnings growth over five years. But, he said, "based on the experience of U.S. companies over the last 50 years, the probability that a large company will achieve such a growth rate is probably not higher than winning the lottery."

Of course, eBay is not the only company for which investors have huge growth expectations. According to Thomson First Call, consensus forecasts of analysts now project that more than 100 other companies will have earnings growth of at least 40 percent, annualized, over the next five years.

While the professors' study was published only last spring, they completed the supporting research in early 2000, as the Internet bubble was bursting. In an interview in May that year, Professor Lakonishok focused on Cisco Systems, whose stock had a P/E of about 190 at the time and was trading near $67 a share. Assuming that its ratio in five years would be 50, and that its stock price would grow 22 percent, annualized, through May 2005, he calculated that Cisco's earnings would have to grow nearly 60 percent a year to support that high ratio. He argued at the time that this was very unlikely.

THOUGH a little more than a year remains on those five-year forecasts, it is clear that investors' growth expectations for Cisco were much too optimistic. Over the last four years, its earnings have grown just 11 percent, annualized. And though its P/E is close to 50, the number used in the professor's illustration, its current stock price, $27.33, is 59 percent lower than in May 2000.

Professor Lakonishok says he believes that investors will be similarly disappointed today if they build a stock portfolio from the many companies whose earnings are projected to grow at very high rates over the next five years.

Mark Hulbert is editor of The Hulbert Financial Digest, a service of CBS MarketWatch. His column on investment strategies appears every other week. E-mail:   strategy@nytimes.com.