Chip Stocks: Are They Really Cheap Relative To Growth?

By William Trent, CFA of Stock Market Beat

According to a recent Forbes.com article, five Chip Stocks are Cheap Relative To Growth.

The stocks of these companies are still reasonably priced relative to expectations for profit growth.The measure here is PEG ratio, calculated by dividing a stock’s estimated price-to-earnings ratio for the next twelve months by its projected long-term earnings growth rate. These stocks have PEGs that are below the semiconductor industry’s average PEG of 1.2, a sign that they might be bargains. All these companies are profitable and carry 12-month forward price-to-earnings ratios below their three- and five- year averages.

We think the article is a good example of why investors shouldn’t take estimates at face value, and of the dangers of quasi-analysis (looking at things without looking into them.) The stocks they name are Analog Devices (ADI), Intersil (ISIL), Microsemi (MSCC), Standard Microsystems (SMSC) and Supertex (SUPX). We’ll just focus on ADI, since we were talking about it anyway.

According to Forbes, ADI is trading at 19x next year’s earnings and is expected to grow at an annualized 20% rate over the next three to five years. Let’s look at those assumptions, and compare them to what ADI has done over the last 10 years, as represented in the following chart.

If you had only this chart to go by, where would you place the dot for 2007 EPS?

1. At $2.06, which is the consensus estimate for next year
2. At $1.84, which is exactly 20% above the current year’s EPS
3. At $1.05, which is where the average for the year following the last two times it was at current levels
4. You would never be so foolish as to guess at such an apparently random number

Given our outlook for semiconductors, we’re going out on a limb with #3, but we’re sympathetic to those who guess #4 as well. It is also entirely possible that #1 or #2 happens but we wouldn’t bet our life savings on it, which is what we’d be doing if we bought the stock based on its low current P/E multiple relative to recent history.

And how about that 20% growth rate for the next 3-5 years? It has certainly sustained such growth in previous 3-5 year periods. It has also declined by 90% over 3-5 year periods, and stayed flat over 3-5 year periods. And all of those 3-5 year periods occurred in the last 10 years. How can anyone dare to invest on such a pinpoint estimate of the near-term growth rate?

Finally, let’s look at the question of whether the “12-month forward price-to-earnings ratio [is] below their three- and five- year averages.” For that, we will look at a monthly chart of the price, along with the P/E range in the lower chart.

http://stockmarketbeat.com/blog1/