Today’s topic is “multiple expansion.”
Multiple expansion is the term Wall Street analysts use to describe the boost a stock receives when investors award that company with a higher and higher valuation.
Imagine, for example, that “Acme Widgets” is a $10 stock that produces $1 per share in annual earnings. At that price, Acme would be trading for 10 times earnings – also called a “price-to-earnings (P/E) multiple of 10.”
Now let’s imagine that investors become so enthusiastic about Acme’s prospects that they bid its price up to $20 a share, even though the company’s annual earnings haven’t budged from $1.
In this circumstance, Acme’s P/E multiple would have expanded from 10 to 20. That’s “multiple expansion.”
Whenever a stock’s P/E multiple is rising, that stock is benefiting from multiple expansion. Conversely, whenever a stock’s P/E multiple is falling, that stock is suffering from the evil twin called “multiple contraction.”
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Not surprisingly, P/E multiples tend to expand during bull-market phases when investors are optimistic… and to contract during bear-market phases when investors are pessimistic.
Most of the time, multiple expansions or contractions take place slowly and merely accentuate the bullish or bearish trends underway at the moment.
But in extreme trading environments, these expansions or contractions can dominate the entire stock market and become the only influence that matters. We call moments like these “buying panics” or “selling panics” – moments when valuations take a backseat to raw passion.
That said, it is easy to see that current market conditions are more bullish then bearish. Stock valuations are hitting all-time highs. That’s a phenomenon that occurs near major tops, not near major problems.
Furthermore, signs of extreme optimism and frothiness have been popping up like mushrooms at a music festival. One of those signs is the lightning-fast pace of multiple expansion that’s taking place in various sectors.
In today’s issue, we’ll consider one multiple expansion “case study.”
And we’ll talk about another sector that hasn’t been hit by multiple expansion – and so still has lots of room for growth…
A Solar Balloon
Daqo New Energy Corp. (NYSE:DQ) is a standout performer from the solar energy industry.
Two years ago, the stock was selling for five times earnings – i.e., a P/E multiple of 5. Just a few weeks ago, that same stock was changing hands for 118 times earnings!
That’s not a typo. Daqo’s P/E multiple expanded from 5 on February 12, 2019, to 118 on February 12, 2021. Because of that spectacular multiple expansion, the stock rocketed 1,700% during that two-year time frame.
For perspective, Daqo’s P/E ratio averaged less than 10 during the entire decade that preceded its recent moon shot.
What’s behind Daqo’s incredible multiple expansion? In a word, exuberance.
During the last several months, investors have fallen in love with “green energy” stocks of all types. This love affair has inspired them to throw money at individual names like Daqo, and also at the exchange-traded funds (ETFs) that specialize in green energy stocks.
I certainly understand that passion.
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During the last four years, I’ve recommended 14 separate trades in the solar energy sector – and my members have made multiple triple-digit gains on those.
But recently, I’ve been standing aside from the solar energy sector. I have continued to recommend indirect plays on renewable energy by investing in battery metal stocks.
In general, these stocks sport much lower valuations than renewable energy stocks yet offer a similar growth profile.
Valuation matters… eventually.
When I first started recommending solar stocks in mid-2017, I almost apologized for doing so. Solar stocks had been such poor performers for such a long time that a reversal of fortunes seemed unlikely to most investors.
To generalize, few investors cared about solar stocks in 2017. But today, even fewer investors don’t care about them. Just four year ago, these stocks were outcasts. Today, they are stock market darlings.
As that old Wall Street saying goes, “No one wants stocks at the bottom, but everyone wants them at the top.”
To be sure, solar energy stocks might continue to zigzag higher, but they are much more likely to zigzag lower, simply because their valuations have reached extreme levels. And generally speaking, the stock market does not tolerate extremes for a long time… which brings us back around to Daqo.
When Valuation Starts to Matter Again
The stock was trading recently for more than 100 times annual earnings. Almost no one would pay such an exorbitant price for a business in the non-Wall Street world.
Would you?
For example, would you pay $1 million for a hamburger franchise that earned just $10,000 per year?
That’s what 100 times earnings means.
I’m not picking on the solar sector. In today’s market, many stocks sell for 100 times earnings, or 200 times, or, for companies with no earnings, infinity times.
The solar sector, for all its investment virtues, is vulnerable to a severe markdown. The sector is simply not producing the kind of robust profit growth that its lofty valuation anticipates.
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Yes, many solar companies are growing rapidly, and will continue to do so. But profit margins in the industry are notoriously thin, and competition is notoriously intense. This is not an industry that will likely produce profit growth in line with revenue growth.
The Invesco Solar ETF (NYSEARCA:TAN), which reflects the MAC Global Solar Energy Index, gives us a nice overview of the entire sector. At 100 times earnings, it is priced for perfection.
TAN’s lofty valuation creates a stiff headwind to additional share-price gains… at least relative to similar stocks that may be trading for much lower valuations.
Just as multiple expansion has elevated the solar sector to nosebleed valuations, multiple contraction might soon suck some air out of this highflying balloon and return it to terra firma.
Buyer beware!
That’s why, in the recent issues of Fry’s Investment Report, I’ve been focusing on stocks and sectors that haven’t been hit by multiple expansion.
For example, over recent weeks, the three 5G companies we follow closely in the Fry’s Investment Report portfolio have reported quarterly earnings.
Collectively, these earnings announcements indicate that 5G technology is gaining significant momentum worldwide.
And in the latest issue of the Investment Report, I made my newest 5G-related recommendation.
This one possesses a dual identity. By reputation, it is the world’s premier content delivery network (CDN) provider. But behind the scenes, it is becoming one of the world’s leading cloud cybersecurity firms.
This company’s CDN serves more than 900 cities in 135 countries, which means it carries about 30% of the entire world’s internet traffic. This business is certain to continue growing, as 5G technology boosts data demand across numerous applications and end uses.
You can learn more about joining Fry’s Investment Report here.
Regards,
Eric Fry
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NOTE: On the date of publication, Eric Fry did not own either directly or indirectly any positions in the securities mentioned in this article.
Eric Fry is an award-winning stock picker with numerous “10-bagger” calls —in good markets AND bad. How? By finding potent global megatrends… before they take off. In fact, Eric has recommended 41 different 1,000%+ stock market winners in his career. Plus, he beat 650 of the world’s most famous investors (including Bill Ackman and David Einhorn) in a contest. And today he’s revealing his next potential 1,000% winner for free, right here.