Groupon Downgraded Due to Growth Appreciation Period  — GAP

Groupon (GRPN) was downgraded from Neutral to Dangerous this week after a rapid run up in its stock price.

Rating changes can happen for any number of reasons. New Constructs’ stock ratings focus on five metrics that measure a business’ strength and current valuation.

Business strength includes the quality of a company’s earnings and its return on invested capital (ROIC). Equally as important, current valuation analysis is based on the expectations embedded in the company’s stock price.

To understand Groupon’s rating change, we must examine the expectations implied by the company’s new, higher stock price.

How do We Measure the Market’s Expectations?

At New Constructs, we use an idea called the “Growth Appreciation Period” to measure the market’s expectations for a business. Warren Buffett refers to GAP as “the moat around a business’ castle.”

GAP is a number that measures just how long a business can be expected to generate superior returns over alternative investments. For this reason, GAP is also referred to as “Competitive Advantage Period.” We use a company’s current stock price to calculate its GAP — the higher the stock price, the longer the market expects superior returns from the company.

How Can You Use GAP?

By using GAP, investors can get a quick and accurate idea of the market’s expectations for a company. Just how long does the market expect superior growth from the company?

Put another way, GAP (growth appreciation period) is the time in a discounted cash flow model that it will take a company to justify its current share price. If you know how long a company must grow and generate higher returns, you can determine if those expectations are even feasible. New Constructs applies this analysis to over 3000 stocks.

What Does GAP Say About Groupon?

Groupon’s higher stock price implies greater expectations for the company’s profit growth. Just how great are these expectations?

Groupon’s GAP (growth appreciation period) is currently over 100 years. This means that the market is expecting the currently unprofitable Groupon to suddenly become profitable and grow at a normalized rate for over 100 years. Raising the estimates of revenue growth will lower the GAP, but Groupon still remains highly overvalued.

Consider the Following:

To justify its current price of ~$7.50/share, Groupon must maintain pretax margins of only 1% while growing revenues at a rate of 25% annually for the next 22 years. Not only is this timeframe over two decades in length, Groupon’s latest earnings and guidance indicate that management actually expects the company’s growth to slow down.

Groupon grew revenues by 27% year over year, in the third quarter of 2014. However, management is expecting this to slow to anywhere from 15%-22% growth in the fourth quarter of 2014. This slowdown in revenue growth continues a long-term trend in Groupon’s sales. Groupon has also failed to generate a profit at all in 2014.

Revenue is important, but a business must generate cash returns to be of value to investors. Groupon has failed in that respect this year. As a result, the expectations implied by the company’s current share price are simply not grounded in the current economics of its business. Investors must be expecting a dramatic turnaround in the business to justify buying Groupon at its current price. As a result, we cannot help but give the stock a “Dangerous” rating.