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Why investors love a double-barreled return

Apple was an investor favourite while its P/E ratio and stock price were both climbing. Now, the tables have turned.


Apple was the darling of North American stock markets for five years after it introduced the iPhone in 2007, and its share price soared above $700 (U.S.) last fall. Then investors panicked, and shares have plunged to about $430, even though Apple is still hugely profitable. How could a company that was so fashionable lose its lustre so fast? The answer has a lot to do with its multiple.

Just about every investor knows that rising earnings usually give a company's share price a boost. The market tends to establish a consensus on the price-earnings multiple for the firm – say, 20 cents for each cent of profit per share.

P/E multiples can change, however, in response to a variety of factors. To make a lot of money, it helps to find a company whose earnings and multiple are both going up, thereby turbocharging your return.

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What causes multiples to grow? Increases in earnings certainly help, but only if they're going up for the right reasons. If the gains are solely due to cost-cutting, a company's multiple may actually decline if investors worry that cuts will hurt the business.

Investors like genuine growth – rising revenues and profit margins. When Apple launched the iPhone and began to dominate the smartphone market, its multiple surged from about 30 to more than 40 within a few months, and its share price doubled. Why? Because Apple's profit margins on phones were much higher than those on its computers and iPods.

Something similar happened in Canada's telecom sector in the early 2000s, as cellphones became more popular. When Telus bought Clearnet, a big independent, in 2000, it leapfrogged past BCE and became Canada's largest wireless provider. Profit margins on cellular were higher than those on land lines, so Telus's multiple climbed higher than BCE's. Generally speaking, the faster a company is growing, and the more economies of scale it realizes, the higher its multiple.

Acquisitions can also boost multiples, especially if they reduce competition. New Flyer, the Winnipeg-based bus maker, has seen its share price rise by almost 50 per cent over the past year, even though its earnings haven't kept pace. Why? One reason was the departure of Daimler Buses from the North American transit market last year. New Flyer then bought its aftermarket parts business.

New Flyer's share price got another shot in the arm in January when a Brazilian bus maker, Marcopolo SA, bought a 20 per cent stake in the company at a premium to the market price. The Brazilians want to help consolidate the North American market.

Brand perceptions can also have a powerful effect on multiples. San Diego-based WD-40 Co. makes the eponymous lubricant. It's not a high-growth business–earnings over the past three fiscal years were flat. Yet its stock trades at about 20 times earnings, which is high for a mature company. WD-40 raised its prices years ago and sales didn't fall. Every few years, an upstart tries to compete – there are no patents. They always fail.

Of course, earnings, share prices and multiples often move in opposite directions. One common reason that P/E multiples shoot up is that earnings have plunged, and that is not a good sign.

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Apple has had other problems lately. After popping up in 2007, the company's multiple started to drift down. The increase in its share price lagged the growth in its earnings. Investors clearly had doubts that Apple's phenomenal growth could continue. Since last fall, its multiple and its share price have both declined.

Investors love a double-barrelled return–a rising share price and an increasing multiple. But if euphoria dissolves into panic, the result is often double trouble.

Value: Accord Financial Corp.

4 per cent dividend yield at recent share price Accord has been astonishingly generous over the past decade by returning almost its entire market cap to shareholders via rising dividends and share buybacks. The Toronto-based niche lender, which makes loans to small businesses against their receivables, has also laid out an expansion plan that should result in accelerating profit growth as the economy improves. Priced at about 10 times earnings, it looks like a bargain.

Growth: Enterprise Group Inc.

15.3 Price/earnings ratio

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Alberta-based Enterprise is in a growing niche of contracting firms that help to build pipelines. Sound exciting? Not on the surface, but if you dig a little, you'll realize that demand for these services is only going to rocket higher. At least some proposed big pipelines – and many smaller ones – will get built to take massive new production of shale oil, bitumen and natural gas to market. Fill 'er up.

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About the Author
Investment Columnist

Fabrice Taylor, CFA, publishes the President’s Club investment letter, for which he and The Globe and Mail have a distribution agreement. More


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