Gauging Forward Return Expectations

November 30, 2022
By Ryan Streilein, CFA
Woman riding bike. West Financial Services

During the depths of the pandemic, work from home businesses were, undoubtedly, huge beneficiaries of consumer demand for their services and products. First-order thinking was rewarded during this period, as investments into these stocks appreciated handsomely. While we experienced some uprooting of our lives and the impact of rapid change, West Financial was also brainstorming ways to intelligently invest in long-term COVID-winners. Exercise equipment manufacturer and subscription service, Peloton Interactive Inc. (PTON), was at the epicenter of this craze (I even got my own bike during this time!). In this article, we will share how we most effectively utilized our research time, by inverting the Total Shareholder Return Framework. These principles are helpful in framing future performance expectations heading into an investment. 

Total Shareholder Return (TSR) = Growth + Multiple Change + Dividend

Looking backwards, we know the inputs and can further break them down into more parts, if desired. Looking forward, we start by assuming an imaginary hurdle rate, or required return on investment. For Peloton, the question posed was, “will an investment in the stock yield our clients a 10%+ annual return over the next 5 years?”

Going back to elementary algebra, the right hand side of the equation needs to match the left side, using any combination of inputs. One path is that the business can grow 10% per year, with no change in investor sentiment (price multiple), and no dividend payments. You can achieve the same result if a business does not grow, but pays out 10% per year in dividends, leaving the multiple unchanged. 

With the required return and time frame specified, the next step is to analyze the financial data. Going back to Peloton’s June 30th, 2020 annual report, the market cap, or company value of $16.6B was 9-times higher than the annual sales of $1.8B. Said another way, the price-to-sales (P/S) multiple was a bit higher than 9x and the company also did not pay a dividend. Here is what we have so far:

10% = Growth + Multiple (~9x) + Dividend (0%)

Now… I did not blindly pass over a very important variable! We are going plug & play with various growth assumptions. Assuming a 10% annual return over the next 5 years, the company value would be ~$26.8B. The table below shows estimated multiples, often called terminal multiples, 5-years into the future. Using this information we back into the implied sales growth necessary to generate our required return. As you can see, if the multiple does not change, growth will need to be around 10% to generate a 10% return. As the multiple contracts, the annual growth needed increases. 

"Table: The graphic shows two implied growth rate tables. Each table has a corresponding 4-columns-by-2-row header. The header columns are identical, containing “Years”, “Market Cap”, “Return”, and “Future Value”. The left-most table header takes Peloton’s (PTON) 6/30/2020 market cap of $16.6B and calculates a 5 year future company value at a 10% growth rate, equating to $26.7B. The 2nd header on the right-most table does the same calculation, but assumes a 15% annual growth rate, equating to a $33.4B future value. Underneath the both headers are two 2-column-by-18-row tables (including 1 header row). The first column contains price-to-sales multiples, and the following column contains growth. In the left-most table, these columns calculates an implied sales growth rate at varying price-to-sales multiples, 5 years in the future. The row of multiples & growth rates start at 1x and 67.5%. The next row of multiple & growth, as referenced in the article is 2x and 47.3% growth. The midpoint multiple row is 9x sales, which equates to the 10% growth rate. The final multiple row is 17x sales which equates to -3.1% sales growth over the next 5 years. The same formula is taken in the right-most table. The row of multiples & growth rates to achieve 15% growth start at 1x and 75.1%. The midpoint multiple row is 9x sales, which equates to the 15% growth rate. The final multiple row is 17x sales which equates to 1.3% sales growth over the next 5 years. Source: West Financial Analysis, SEC.gov"

Source: West Financial Analysis, SEC.gov

This general guidepost shows us various return paths that PTON could take. In January of 2021, valuation hit a peak of almost 25x sales, inflating the market cap to almost $50B and making the company larger than two-thirds of the S&P 500 at the time. Comparatively, the S&P 500 has an average Price/Sales of about 2x over the past 10 years. For sake of example, if PTON traded at a market multiple in 5 years, the company would need sales of around $13B (47.4% annual increases from $1.8B) to earn a 10% return annually. How feasible is this? According to the Base Rate Book, historical data tells us that only ~1% of companies from 1950-2015 have ever grown sales >45% annually over a 5-year time horizon. 

In hindsight, we were fortunate to avoid adding Peloton to the portfolios, but plenty of investors get caught up in the hype and extrapolate results well beyond reality. Others may be playing a different game, focusing on a shorter time horizon. Just a couple years later, PTON now trades at ~1x sales with the market capitalization below pre-pandemic levels, nearing $3 billion. 

"Table: The graphic includes two separate tables (5-columns-by-21-rows) with Base Rates for two different sets of data. The left-most data table contains historical success rates, otherwise known as Base Rates, for companies in the $1.25-$2B sales range while the right-most data table contains the full universe. In the left-most data table, the first column contains sales CAGR (%) groups for 5 percentage point increments ranging from <25% to >45%. Reading left to right, the table column header contains 1-yr, 3-yr, 5-yr, and 10-yr timeframes. Navigating to the interior of the data table, the Base Rates are stated. The first line across the upper-left most corner, says that 1.4%, 0.3%, 0.3%, and 0% of companies with sales of $1.25-$2B declined more than 25% annually over a 1-yr, 3-yr, 5-yr, and 10-yr timeframe, respectively. As referenced in the article, the bottom row in the interior of the data table indicates that 5.8%, 2.3%, 0.7%, and 0.1% of companies with sales of $1.25-$2B grew more than 45% annually over a 1-yr, 3-yr, 5-yr, and 10-yr timeframe, respectively. The bottom 3 rows of the table include Mean, Median, and Standard Deviation metrics for the whole data sets. Source: The Base Rate Book"

Source: The Base Rate Book

"Chart: Peloton Interactive, Inc. Class A (PTON) price to last twelve months (LTM) sales. Price to sales (LTM) multiples on right axis ranging from 0.5x to 24.0x, time periods on horizontal axis.  Price / LTM Sales indicates the multiple of sales that stock investors are willing to pay for firm’s market value. Time periods are quarterly beginning with October 2019 through November 2022. October 2019 is 7.7x. January 2020 is 7.7x. April 2020 is 6.0x. July 2020 is 11.3x. October 2020 is 11.7x. January 2021 is 20.8x. April 2021 is 13.3x. July 2021 is 10.3x. October 2021 is 6.0x. January 2022 is 2.5x. April 2022 is 2.0x. July 2022 is 0.8x. November 2022 is 1.1x. Source: FactSet Database"

Source: FactSet Database

The TSR framework focuses West Financial on the long-term and shines a light on the potential end results by illustrating the magnitude that sentiment (multiple) changes have on growth expectations. The framework also focuses our analysis on fundamental value drivers. Once the due diligence process is completed, we can also use this framework to help compare different investment opportunities in a portfolio.

Bonus points if you made it this far. As an additional perspective, the graphic below does a great job explaining this concept with real world examples. The chart shows the P/E that an investor could have paid in 1973 in order to achieve a 7% compound annual return over the next 46 years (to 2019). Companies can indeed provide decent returns when purchased at high valuations, but the margin of safety is quite low due to the persistence & longevity of growth. 

"Chart: Justified Price to Earnings Ratio in January 1973. This shows the P/E that an investor could have paid in 1973 in order to achieve a 7% compound annual return over the next 46 years (to 2019). Numbers on left axis ranging from 0 to 300, various companies listed on horizontal axis.  L’Oreal 281.  Altria-Group 241.  Lindt 230.  Brown-Forman 174.  Hershey 129.  Colgate 126.  Heineken 115.  Beiersdorf 106.  Pepsico 100. Pernod-Ricard 72.  Kellogg 70.  BAT 65.  Coca-Cola 63. Clorox 55.  Reckitt Benckiser 52.  Nestle 51.  Danone 48.  Smucker 47.  P&G 44.  General Mills 36.  Carlsberg 35.  Unilever 31.  Diageo 21.  Campbell Soup 16.  Avon 0."

Source: Fundsmith 

Additional Resources:
-    The Base Rate Book 
-    Future - When Entry Multiples Don't Matter 
-    Verdad - What's in an Equity Return? 
-    SEC.gov

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