Zachary is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
Sometimes conventional wisdom is just downright wrong...
For example, let's take a quick look at the way most investors apply the concept of "valuation" to their trading decisions.
As a general rule, conventional investors like to buy stocks with cheap valuations, and they avoid stocks that have high price to earnings (PE) ratios.
On the surface, the concept makes sense. If you pay a premium price for a stock, you have more risk of a decline in price, and less potential appreciation for your investment.
For decades, financial academia has told us to "buy cheap and sell dear" - causing too many investors to miss out on some of the best growth opportunities available. This is because growth opportunities typically trade with lofty valuations as investors bid the stock higher in anticipation of future earnings growth.
The key to success when investing in growth stocks is to look at two key components:
How robust is the fundamental growth of the underlying company?
How will future investors react to the growth characteristics of this company?
You see, ultimately the academics are correct... Stocks will eventually trade in line with their long-term earnings profile.
But during the early growth stages of successful companies, the stock price can remain significantly above traditional "fair value" metrics for a long period of time. The question is whether the company "grows into" its inflated stock price, or if the stock eventually declines to match the fundamental picture.
Today, I want to take a quick look at Five Below (NASDAQ: FIVE), a teen retail growth stock that is trading with a lofty valuation but plenty of potential for future growth.
Five Below currently has a market cap of $2.1 billion as investors begin to embrace optimistic expectations for future growth. But the stock should have much farther to run as analysts revise estimates higher and investors continue to compete for shares of this attractive retailer
Robust revenue and EPS growth
Five Below is a specialty retail chain, catering primarily to teen and pre-teen girls, selling accessories priced at $5.00 or less. The concept is an interesting blend between the fashion retail industry (which has seen a significant amount of growth) and the discount retail industry (also an attractive sub-industry).
As the father of five pre-teen girls (yes, you read that right), I can vouch for the allure of these low-priced novelty shops.
In many ways, the teen and pre-teen retail market is broken into two primary categories. The premium stores - like Abercrombie & Fitch, The Gap, and True Religion (NASDAQ: TRLG) - cater to affluent shoppers with virtually unlimited budgets.
For example, a quick search for True Religion jeans yields a pricing list with some priced at several hundred dollars. The high pricing has resulted in fat margins for the company, with last quarter's gross margin coming in above 60%.
As a side note, True Religion just announced that they are being acquired by Tower Brook Capital Partners, so it will not continue to trade as a public company.
On the other side of the continuum, there are more economical chains such American Eagle Outfitters and Urban Outfitters (NASDAQ: URBN) which offer quality trends at more reasonable prices.
Urban Outfitters has a much more reasonably priced product line, and appeals to more mainstream budget-conscious shoppers. As a result of lower prices, the company has tighter margins. In the most recent quarter, Urban Outfitters posted a 36.8% profit margin. This was obviously well below True Religion, but with the company's broader reach, profits still beat expectations.
As a general rule, it is easier for the chains to grow revenue because they have a wider base of potential customers (the budget-conscious) to market to.
In the case of Five Below, the company has used its attractive prices to grow revenue AND earnings over the past year, and the most recent commentary from management looks very attractive.
After a rough start to the first quarter, sales picked up sharply allowing Five Below to raise estimates for first quarter earnings.
More importantly, the company is on track to open 60 new stores this year, as it expands into new geographic markets and broadens its overall footprint.
Assuming the company's merchandising strategy continues to appeal to customers, Five Below should be able to exceed analyst EPS estimates of $0.67 this year and $0.90 next year.
Estimate / Valuation growth: A virtuous cycle
There is a phenomenon for growth stock investors that I like to call the Estimate / Valuation Virtuous Cycle. The cycle works like this...
As a growth company reports increases in both revenue and earnings, analysts begin to upgrade their estimates for the company. We see this in many industries as a concept evolves and catches more and more attention. Historical examples of these earnings estimate revisions include the mighty Apple, Chipotle Mexican Grill, Salesforce.com and many many more...
Institutional and retail investors see earnings estimates being revised higher, and they instinctively place a premium valuation on the stock. It makes sense for investors to pay this "growth premium" because future earnings are expected to be so much higher in the future.
With both of these forces working together (higher estimates and inflated valuations), traders can capture triple-digit returns very quickly.
For example, take a company that is currently expected to generate $1.00 per share and trading with a forward PE of 15 (the stock would be trading at $15.00 per share).
If fundamental strength causes analysts to increase their earnings estimate by 50%, and at the same time, investors are willing to pay a 25 multiple, we suddenly have a geometric increase in the stock price. (In this example, the stock would rally 116% to $37.50.
And this isn't really an extreme example. There are plenty of instances where growth stocks have commanded multiples of 40, 60 or even 100 times forward earnings, while analysts continue to revise their estimates higher.
The Outlook for Five Below
Five Below appears to be in the early stages of this virtuous cycle. As the company continues to execute on its growth plan, I expect analysts to increase their forward estimates - and at the same time, investors will gain more confidence and be willing to pay a higher premium.
Even though the stock holds a market cap of $2.1 billion, the attractiveness of the overall concept, and the blue sky in terms of available markets for the company to move into, leaves plenty of room for a significantly higher market cap.
It's very difficult to place a price target on a retail stock with so much room for growth. The company has a relatively narrow footprint in the US - with several years worth of expansion possible before even thinking about international expansion.
Five Below is operating in a particularly attractive sub-category of the retail market. Last month's retail sales data revealed surprising strength, with the apparel and general merchandise areas standing out as strong winners.
The stock is a recent IPO (within the past year) and is still building its institutional following, which should represent a strong source of demand for shares of the stock. Over the next year, it wouldn't surprise me at all to see the stock make large gains in price as the growth concept gains traction.
Zachary Scheidt has no position in any stocks mentioned. The Motley Fool recommends Apple, Chipotle Mexican Grill, and Salesforce.com. The Motley Fool owns shares of Apple and Chipotle Mexican Grill. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. Is this post wrong? Click here. Think you can do better? Join us and write your own!