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Go Pro: An example of why you should learn from history

Tuesday, November 3rd, 2015
 

I have been in the investment business for about 33 years now, and I still don't understand why investors overpay for a company stock based on the price-to-earnings multiple.

Robert Schiller, a well-known professor of Yale University and an American Nobel laureate has discussed many times about overpaying. Looking at a chart going back before the year 1900, it is clear to see that if a smart investor paid 10 times earnings for a stock in 1920, 1950, or 1982, they received excellent returns. However if investors bought when the PE was the highest in 1929, 1969, 2000 and 2008, they saw the opposite effect and experienced large losses.

The concept is quite easy- look and understand the earnings per share of a company, don't overpay for them and when they reach an unreasonably high number (or for us a high average), sell the company. Staying at the party for too long is never a good idea no matter what the party is.

A company that has recently fallen out of favor and never really had the earnings to support the price of the stock is GoPro Inc. (GPRO).  I'm sure you heard of the company but in case you haven't, they became famous for having cameras that would take videos virtually anywhere.

While the concept was unique, it was a one-trick pony and is now struggling. And to add insult to injury they are now being sued by Polaroid for a patent infringement. Whether it is true or not doesn't matter; the problem is they will now have to spend money and time to defend their product.

With all that said, I do get interested in a company that reached a high of about $93 a share a little over year ago and has now fallen to around $25 per share.

When I first began looking at the fundamentals of this company I was happy to see that the company has a price-to-earnings ratio, because that tells me over the last 12 months the company has had earnings. The current PE is 20.8, well below the Industry average of 89, which in itself is just ridiculous- it is the industry of photography equipment.

Price-to-sales is another way to look at what one is paying for a company, and GoPro investors are paying 1.89 versus 0.85 for the industry. This is crazy; the industry comparison of the price-to-tangible book value for the industry is 76.1, while the company is 4.6.

Even the price-to-cash flow is a number that makes no sense. The industry is at 43.8 compared to the company, which is at a more reasonable 15.8. 

The sales growth for this company is probably what sent the stock to levels that were unsustainable. Year-over-year sales grew by 62%, when the industry only managed to grow their sales at a rate of 8.3%. The year-over-year earnings growth also looked impressive, climbing 377% and beating the industry average of 142%.

I always point out to investors it's easy to grow sales and earnings off of a low base, so one must understand what the size of the earnings and sales really are.

When investing into a new company (and remember this company went public in June of last year), make sure the company has a strong balance sheet so they can weather the storm going forward. GoPro does have a good balance sheet with a current ratio of 2.90, which is above the industry average of 2.44.

Once again it amazes me how crazy this industry is because of a high valuations, and now I see the industry average debt-to-equity is 122.4. I'm happy to report that GoPro has managed to grow itself and has put no debt on the balance sheet.

Also important is the return on equity that a company generates. I see a very good number from this company at 30.0, compared with the industry average of 4.2. I get pretty happy when I see a return on equity of 15 or better, so 30 is a phenomenal number. The net profit margin for GoPro stands at 10.6%, well above the industrial average of 1.0%. 

The efficiency of a company managing the receivables and the inventory can either make or break that company. GoPro is doing a great job on both of these, with the receivable turnover at 16.9 for the last 12 months, compared to the industry average at 6.7. The inventory turnover of the last 12 months while not as impressive, still came in at 4.8, a little bit better than the industry at 4.2.

So everything on this company looks really pretty good so far right? As I said in the beginning, the problem comes back to earnings and what an investor pays for the earnings.

Since this is November I will look ahead to December 2017, with earnings-per-share estimated at $1.40. And these are the more stringent earnings known as GAAP (Generally Accepted Accounting Principles).

Using the 40 year average of 16.5 for the forward PE, that would yield a target sell price of $23.10 which is unfortunately below the current price of around $25 a share. I know some investors will use the less restrictive pre-exempt earnings per-share for December 2017 of $1.80, but even as loose as that number is, it still only gives you a target sell price of $29.70. I personally would never use that number; it's too much of a “pie in the sky” type number.

So most of the numbers look good for GoPro and I know the stock could turn around and go back up, but I would rather be conservative on my investing. Based on history, not overpaying for the earnings of any company has proven time and time again the smartest way to grow your portfolio over the long term.

For me to invest in this company the stock price would have to fall to the mid-to-high teens, or the earnings estimates going forward would have to increase by about 35%. Remember, be careful what you pay for the earnings of a company. 100% of the time history has proven investors who overpay end up on the losing side over the long term.

So don't be too excited if you have done well over the last year or two; depending on your age you could still be investing for 20 to 40 years. Please learn from history and don't think it will be different this time, or that the company that you're investing into is a unique circumstance. Every company will come back to the mean price-to-earnings ratio of 14 to 16 times earnings.

Do you have a question or a company you would like us to take a look at?
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