<<Both companies made about the same amount of money last year and are likely to grow at a 40% rate for at least the next 2 years. A more appropriate valuation would give each company a P/E = 40 after subtracting out the book value, which is higher for Wind River than Radisys.>>
The primary issue when trying to value high-growth companies is assessing future growth prospects. The widely used "PE = growth rate" rule is an extremely crude tool. The problem is that it is linear while growth is exponential. Suppose you buy company A, growing steadily at 25% per year with a PE of 25 and company B, growing steadily at 40% per year with a PE of 40. After 6 years, company A has grown by roughly a factor of 4 while company B has grown by roughly a factor of 8. If the profitability and PEs remain the same, the investment in company B is clearly superior.
The truth is that it is extremely hard to overpay for a company that subsequently grows fast for several years. But it is very easy to overpay for one that only looks like it will. The difficulty comes in recognizing the difference beforehand. Take a look at the history of Microsoft's stock price. It has always looked expensive, but it just keeps going up! Eventually of course its growth will slow, if only because the annual sales become a significant percentage of world gross product. If "eventually" is long enough, Microsoft is still a great buy. If "eventually" is next year, it is a terrible buy.
These comments of course refer to long term investing. Short term investors can make or lose large amounts of money on both the long and the short side of high-PE stocks because of the volatility. And the volatility is a natural consequence of the need to forecast future growth. If the prospects for company A suddenly improve, it can very quickly become priced like company B. The flip side is that a company whose growth rate drops can be slammed very hard.
My opinion, apparently like that of most people on this thread, is that WIND has many years of above-average growth ahead of it. In several years time, when WIND is trading at $200 (before splits), I won't really care whether I paid $20, $30 or $40 for it. But I will be really sorry if I sold some in the interim trying to get a short-term profit and never found a good re-entry point. And, of course, when it is trading at $200, there will be people complaining that it is really only worth $150 and others claiming it ought to be $250 already. That is the nature of the game. |
