Investors tend to associate Ben Graham with value investing, but the master investor had an opinion on growth stocks too.
Usefully for us, Mr Graham developed a very effective simplified alternative to discounted cash flow valuations.
The Graham Formula, as it became known, provides an estimate of the intrinsic value of a growth stock over a 7-10 year period.
Here’s the formula. Note that it can easily be rearranged to calculate the growth rate, g, using the current share price:
Intrinsic value of stock = EPS * (8.5 + 2g) * 4.4 / Y
(EPS = last reported adjusted earnings per share, g = long-term forecast earnings growth rate, Y = yield on 20-year AAA-rated corporate bonds — see here)
How is this relevant to ASOS?
With this in mind, I was interested to come across an old article by Stockopedia founder Ed Croft which used the Graham Formula to value ASOS plc (LON:ASC), back in February 2012. At the time, the online clothing retailer’s shares were trading at around £18, which seemed expensive enough and implied a 7-10 year annualised eps growth rate of 27%. ASOS shares did of course quadruple in value from this point to last year’s £70 high, before crashing back down to trade at their current price of around £28.
Given the strong performance of ASOS stock, you might think that ASOS has been outperforming its implied 27% annual eps growth rate since 2012. Yet it hasn’t. After Ed’s article was published in February 2012, ASOS went on to report a 67% fall in earnings per share for 2012, before recovering somewhat in 2013 and 2014.
Over the three years from 2011 to 2014, ASOS delivered annualised earnings per share growth of just 5% per year! Of course, three years is much less than the 7-10 year timescale specified by Ben Graham, but a 27% annualised growth rate still seems a bit ambitious.
Whare are growth expectations today?
Given this, what does today’s ASOS share price imply about future growth, using the Ben Graham Formula?
I’ve crunched the numbers, and the current ASOS share price of 2,850p implies an annualised growth rate of 19% per year for the next 7-10 years. Is that reasonable? It’s certainly not impossible, if ASOS achieves its goal of becoming the Amazon of online fashion retail, but it’s a demanding goal.
ASOS’s recent results suggest that selling online is not more profitable than selling on the high street — ASOS’s operating margin of around 5% looks pretty dismal alongside the 20% margin generated by Next — and I think it’s fast becoming obvious that there is no secret sauce that makes online retailers better businesses than those who trade on the high street as well.
More to the point, today’s valuation of ASOS leaves no room for disappointment, and little room for ASOS to exceed expectations. Given that growth stocks typically only outperform the market when they exceed expectations (or when a bull market gets out of control), I don’t see any reason to buy ASOS at today’s price.
Mind you, that’s what Ed said back in 2012 — since when ASOS shares have gained another 60% or so… It just goes to show that while statistics and modelling can be a useful guide to market-wide returns, almost anything can happen to individual stocks — although personally, I am still pretty sure ASOS is overvalued.
Disclaimer: This article is provided for information only and is not intended as investment advice. The author has no interest in any company mentioned. Do your own research or seek qualified professional advice before making any investment decisions.