The stock of video-camera maker GoPro (GPRO) is having another banner day, blasting up 5% on news that the company is launching some new cameras.
The stock is now at $US87, double where it was a month ago and more than 3X its IPO price in June.
Since the IPO, of course, a parade of market pundits has declared GoPro’s stock performance an obvious sign of insanity. And if the stock price was obviously crazy three months ago, it’s presumably even more obviously wacko now at more than twice the price.
So, is it really crazy? Or are GoPro speculators reasonably assessing the company’s long-term opportunity?
To answer that question definitively, you would have to know what GoPro’s financial performance will be for the next 100+ years. You would also have to discount that performance (annual cash flow) at a rate that appropriately compensated you for the risk associated with the stock.
Without knowing those things, we can’t know for sure whether GoPro’s valuation is “insane” until we see how the future unfolds.
But here’s one way to think about it.
In their early rocketship-growth years, high-growth stocks can often trade at very high multiples of earnings or revenue. Inevitably, however, at some point, growth slows, and stock multiples compress. Eventually, the stocks of all healthy companies usually trade in a range of about 10X-20X earnings — which is to say, they trade at average market multiples.
So if you want to get a sense of whether GoPro’s valuation is nuts, it’s helpful to think about what level of earnings would be required to support the stock’s current and future valuation.
(By the way, if you don’t believe that the stocks of today’s hottest stocks will eventually trade at 10X-20X earnings — or lower — just look at what happened to the hottest stocks of the 1990s. The stocks of Yahoo, Cisco, Microsoft, and many other red-hot tech companies were trading at extremely high multiples — often 50X-200X earnings. Today, these stocks all trade at 10X-20X earnings. Today’s high fliers will be no different.)
So how much profit would GoPro have to generate to justify today’s valuation?
Let’s run the numbers…
GoPro’s current market value is $US11 billion.
Right now, GoPro isn’t making money, but that’s ok. Growth-stock valuations aren’t based on what the companies are earning today. They’re based on what the companies are expected to earn in the future. As long as future profits are enough to allow the stock’s multiple to “regress” to an average level and still provide today’s investor with a reasonable rate of return, then the stock’s current multiple is irrelevant.
At 10X-20X earnings, GoPro would need profit of $US550 million (20X earnings) to $US1.1 billion (10X earnings) to support its current market capitalisation.
If GoPro earned $US550 million – $US1.1 billion in 10 years, and the stock traded at 10X – 20X earnings, then the stock would fairly trade at about the same level as today.
Of course, most of today’s investors would be unhappy with that performance. They would want and expect a healthy annual return.
How big a return?
Well, given the high level of uncertainty and risk around GoPro, most investors would probably want the stock to at least double over 10 years if not triple.
So, we have our answer.
To justify today’s stock price on the basis of discounted cash flow, GoPro will have to generate $US1 billion to $US3 billion of profit in 10 years.
How likely is that?
Well, GoPro is currently generating around $US1 billion of revenue on an annualized rate. GoPro is primarily a hardware company, and hardware companies generally have low profit margins. GoPro is trying to become a media company, and media companies can have higher profit margins. So a reasonable future profit margin assumption for a successful GoPro might be, say, 15%.
To generate $US1-$3 billion of profit at a 15% profit margin, GoPro would need revenue of $US5 billion to $US15 billion.
So we have another way of looking at our answer. To assess whether GoPro’s current stock price is “insane,” we have to ask ourselves how likely it is that GoPro will grow its annual revenue from $US1 billion today to $US5-$15 billion in a decade and generate a 15% profit margin.
If GoPro remains the only sport video camera maker that anyone has ever heard of, and if GoPro successfully builds a media platform that makes it the only real choice for anyone who wants to record action video (thus increasing profit margin and lock-in), then the idea that GoPro will grow revenue to $US5-$15 billion in 10 years doesn’t seem insane. It’s a big world, and lots of people will want cameras like GoPros.
If that line of thinking makes you think that GoPro at $US87 is a slam-dunk great investment, it’s worth sketching another possible future for GoPro.
Five years, when it came to digital video, Flip cameras were all the rage. People were so stoked about the future of Flip, in fact, that Cisco paid $US500 million for the company.
Then the iPhone arrived and obliterated Flip. And Cisco was forced to shut it down and write off the whole thing.
That’s how it often goes in the hardware business (and, for that matter, in other fast-moving businesses).
So anyone who thinks GoPro is assured of even 10 great years of growth, let alone a century, is hallucinating.
Let the speculation continue!
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