The Current Valuation Of 5 Top Stocks Should Preclude New Investment

Investing 101

Most (if not all) individuals that invest in anything will only do so with the expectation of earning a positive return. When deploying capital in the stock market, a company's earnings growth is perhaps the best metric by which an investor can monitor and gauge the performance of his or her investment relative to other opportunities. Typically, as a company grows its earnings an investor can expect the value of his or her investment to grow commensurately. It is the perceived opportunity to participate in the expected upside of a company's future performance that ultimately incentivizes and compels an individual to make an investment in the first place.

Will there always be an abundant supply of new investors regardless of price?

The beauty of our stock market is that it is highly liquid. An investor that buys into a company today can be confident that there will be a buyer for his or her shares, ideally at a premium to their original purchase price, whenever they wish to sell. But what happens when the market price of a stock becomes so disconnected from corresponding operational performance that too much future upside has already been priced into shares? Will rational investors always be willing to purchase an overvalued equity with the expectation that the market will forever value those shares at an inflated earnings multiple? Probably not.

Individual stocks sometimes become so overpriced that they no longer offer new investors the same inherent opportunity to participate in the near-to-medium-term earnings growth that current (and previous) investors realized. That said, why would someone pay an existing shareholder for multiple years of yet unrealized growth when there is no guarantee that future investors will be willing to pay a similar premium when they are eventually ready to sell? Inevitably this conundrum begins to alienate many prospective investors and the overvalued shares generally sell off as, without an abundance of new buyers, current shareholders are largely left to trade amongst themselves.

The 'Fab' 5: 5 years of growth already built into today's prices

I have identified five widely-followed stocks that trade at such an elevated valuation that no rational investor should be willing to establish a new position at current levels: Lululemon Athletica (LULU), Chipotle Mexican Grill (CMG), Amazon.com (AMZN), Salesfore.com (CRM) and LinkedIn (LNKD). The table below reveals that the market has essentially stripped out five years of returns for a hypothetical new investor by already pricing in the expected upside of earnings through at least 2016.

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I calculated 2012 and 2013 forward price to earnings [PE] ratios using the analyst estimates for each company as compiled by Yahoo! Finance. I then calculated expected earnings per share [EPS] growth from 2012 to 2013 and carried that rate forward to estimate the forward PE ratios in years three through five. Carrying 2013's year-over-year EPS growth rate forward through 2016 is an aggressive assumption; the projected forward PEs for each company in 2014-2016 are quite likely much lower than what they will ultimately prove to be particularly given that many analysts are calling for material appreciation to these five companies' stock prices in just the next twelve months, let alone five years.

Assuming a reasonable 'target' PE of 20, as of Wednesday's close, Lululemon, Chipotle and LinkedIn have five years of substantial earnings growth already priced into their shares. I am skeptical of LinkedIn's ability to grow earnings at 73% per annum through 2016 and as such the shares are likely even more overvalued than the table suggests.

Similarly, Amazon is projected to grow EPS by 103.9% in 2013. Replicating such performance in 2014 and 2015 would give AMZN a reasonable PE of 17.9x were the stock to remain flat for four years. In a more realistic scenario, were Amazon to only grow earnings at 50.0% in 2014 and 2015 its PE in 2016 at $193.99 a share would be 22.0x. Salesforce.com represents the most overvalued stock of the five. Assuming 29.2% perpetual EPS growth, the company's PE would not approach 20x for seven years when in 2018 it would be 20.8x given an unchanged share price of $155.68.

With growth already priced in, future returns will be inherently diminished

I am not suggesting that any of the aforementioned companies will never eventually grow into their current valuations. I am simply highlighting the fact that current prices should and most likely will preclude substantial new investment in each of these names as the shares have essentially stripped out five years of earnings upside by already factoring that growth into current prices. Most investors, including large institutions, are going to be deterred from establishing an initial position in these names because, given the historical norm of PE ratios constricting over time to approach the market mean, the likelihood that buyers five years in the future will be willing to pay for another five years of growth upon initiating their position is slim at best.

I expect that the exorbitant valuations of these five companies will alienate new buyers as their ability to participate in near-to-medium term upside will be diminished. Further, even if earnings growth remained strong beyond year five, eventually the corresponding increase in share prices would be expected to lag earnings growth as the PE multiples will eventually trend lower. Given an anticipated deficiency in fresh money willing to establish a new position at current levels, I feel that all five of these names can be shorted into any overall market weakness.

Disclosure: I am short CMG.