The High PE Bait and Switch
High PEs aren't justified by the source of some tech companies' recent earnings
We have seen a big push by the market into several relatively young tech companies of late. In many cases, these companies are still losing money under GAAP accounting rules. However, many are adding back several often-recurring expenses to produce non-GAAP income that may allow a small profit, or at the worst, a much smaller loss. We have discussed the makeup of GAAP vs. non-GAAP many times.
What we want to focus on in this issue are changes in market-driven items that the companies have zero control over which are benefitting both GAAP and non-GAAP results. These include higher interest rates and a 2022 change in GAAP accounting rules. A significant portion of recent GAAP and non-GAAP earnings have been a result of these two non-operational items.
The reason this is important is these companies often have P/E ratios of 80-150x forward-looking non-GAAP estimates. We already know non-GAAP EPS is an inflated figure, otherwise, “why bother using it?” However, if 20%-50% of the non-GAAP EPS is coming from non-operational sources and that is more than half the reported growth – the non-GAAP P/E for actual operations is much higher. The risk is if that source of growth merely levels off, the P/E ratio may contract substantially, and the stock price goes down or nowhere even with some overall non-GAAP EPS growth.
There was a time when Walmart was the high-flying stock with a lofty P/E ratio. Over a 4-year period, the stock rose 600%. By the end of 1999, WMT was trading for $69 with a P/E of 57x 2000’s EPS of $1.21. For the next decade, WMT’s EPS continued to grow with a forecast of $4.18 for 2010. Even Miss America was telling investors to buy the stock. But the stock from 1999-2009 traded between $46 and $53 which resulted in a a P/E of about 10-12x that 2010 EPS figure. The market did not believe future growth could duplicate past growth rates and the stock languished as its P/E ratio fell even while EPS rose. We wonder if the same fate may await some of these high-flying tech names.