The belief that because a company has top-notch growth prospects it is always a buy is a dangerous one. For example, investors who paid $40 for shares in profitless accounting software company, XERO FPO NZ (ASX: XRO), are nursing a 30% paper loss after just a couple of weeks. There's no doubt that Xero will succeed in selling its software, but it's hard to imagine why Mr Market thought company was worth as much as REA Group Limited (ASX: REA) is today, prior to making even a single dollar. It goes to show the importance of attempting a reasonable valuation of a company, before buying shares in it.
But even buyers of REA Group at current prices are probably getting it wrong. As with Xero, REA Group is very likely to grow profits over the long term, but that doesn't mean it's a buy at current prices. Most pundits who recommend buying shares in the company merely point to its impressive history of dividend, earnings and, believe it or not, past share price growth. This emphasis on the past is likely to distract potential investors from what really matters: the future.
It is highly likely that REA Group will continue to grow profits for years to come. However, depending on the discount rate and terminal value used, the company is priced for 15% – 25% free cashflow growth for the next decade. While REA Group certainly can find opportunities to reinvest its profits at an enticing rate, it has to be said that return on internal investment has become consistently less enticing as the company has grown. The risk that the company might miss the consistently demanding long-term target set by Mr Market, apparently does not concern current buyers, who risk unsatisfactory returns if the company fails to deliver impressive growth even five years hence.
REA Group may make most of its profits from one relatively small market (real estate advertising in Australia), but crazy old Mr Market thinks it has better growth prospects than the king of the tech companies, Google Inc (NASDAQ: GOOG). This is obvious through a simple comparison of very basic measures. Behold:
Google:
Comprehensive income year ended 31 December 2013: $12.5 billion
Net cash at 31 December 2013: $13 billion
Market capitalisation 14 April 2014: $358 billion
Trailing P/E ratio (excluding cash): 28.6
REA Group:
Annualised earnings based on half year to 31 December 2013: $140 million
Net cash at 31 December 2013: $286 million
Market capitalisation on 14 April 2014: $5.87 billion
Trailing P/E ratio (excluding cash): 39.8
Foolish takeaway
Buyers of REA Group shares at $45 are basically saying they think the company has better long-term growth prospects than Google. To me, this is ironic, because Google is one of the few companies that would be capable of seriously competing with REA Group. Indeed, Google's recent move into hotel listings does not bode well for realestate.com.au.
Today's buyers of REA Group may receive a reasonable return over the long-term, but there are plenty of far more attractively priced stocks on offer. REA Group is a hold at best. Google, on the other hand, might be worth buying soon, especially if the price continues to fall over the next few weeks.
