Above the NOISE: Growth and valuation are not linear

The debate about Facebook on TradingFloor.com has of late been very diversified and yesterday my good colleague Matt Bolduc wrote about how much Facebook's innovation is worth. In subsequent commentary I promised to contribute some insight on valuation in relation to owning a near monopoly and elaborate a bit on growth versus valuation.

The PEG ratio is flawed
Somehow the PEG ratio (Price-to-Earnings ratio / Expected growth rate) has crept up and become a "household" ratio of retail and some institutional investors. The problem with the PEG ratio is that it assumes a linear relationship between growth and valuation. Purely on a theoretical basis this is wrong (see the chart below).

Source: University of Nevada

But more importantly it is completely detached from how financial markets price growth. As we showed through a multiple regression analysis on S&P 500 companies some time ago the relationship is non-linear (see chart below) thus supporting the finance theory.

This observation is very important to understand as it supports my view that Facebook could turn out to be a winner stock. The fact that growth and valuation do not have a linear relationship is the reason why Facebook could produce good returns to shareholders over 3.75 years as I wrote the other day. My assumption was based on Wall Street's estimates for net income in 2015 and a P/E ratio of 40. The expected P/E ratio is based on the net income YoY growth rate of 30 percent in 2015 (Wall Street's estimate) and Google's historical relationship between growth and valuation. Now if you look at the chart above you can see that if Facebook's 3-year annualised growth rate is 20-30 percent at the beginning of 2016 then we would expect a P/E ratio of around 25-55. So a P/E ratio of 40 at the beginning of 2016 as the basis for my optimistic view is maybe not that far out. Facebook's near monopoly in social networks would certainly be supportive of a high valuation as well. Let us look at Coca-Cola for an understanding.

Coca-Cola: Why a brand and high market share matter for valuation
We all know the story about Coca-Cola and how successful it has been. The chart below shows you why the company's total return has been 16.2 annualised since 1980.

In the period 1980-2011, Coca-Cola's sales and EPS median YoY growth rates were 8.1 percent and 10.1 percent respectively and the median P/E ratio was 21.5. Most investors would agree that Coca-Cola has had and probably still has a rather high valuation in relation to its growth rate.

I would argue that part of the explanation is its powerful brand, resistance to bad economic times and moderate but stable growth. All these characteristics are likely explanations for why investors are willing to pay such a high price. The chart below shows Coca-Cola's cyclical adjusted earnings per share YoY growth rate. As you can see the growth rate barely went down during the Great Recession in 08'.

For a forseeable period I believe that Facebook's abnormal growth rate, in combination with stable earnings (just look at Google's online ad business), unique brand among millions (if not billions) of consumers and extremely high market share are characteristics that are likely to support a higher valuation than normal.