Yesterday I bought some PEB shares based on some logic around PEB’s total addressable market and a CM valuation relating to FPH’s price to revenue multiple. Today I’m selling those shares and this article explains why.

After buying my PEB shares yesterday, I read a post on ShareTrader which said:

“…If PEB became a buyout target in next 12-24 months, in order to justify a SP of >$1 it would need to generate annual revenue in the vicinity of USD$180M…”

Drcjp – ShareTrader

My first reaction to this was that it seemed ridiculous given the current share price, so I started looking at the numbers a different way to set about justifying my thinking to debunking the idea in my head.

I figured that a mature company would be priced on profits, rather than revenue, so I decided to turn to FPH to look at what sort of profits they make instead of looking at the lofty multiple of revenue comparison.

It seems that 23% (let’s pessimistically say 20% for the comparison) of FPH’s revenue translated into NPAT, so I decided to look at how much of the US market PEB would have to own in order to justify the current share price based on a multiple of NPAT (which I decided would have to be below 20 for a mature company [of 25 for a growing company], because no one would invest for years with the hope of earning 5% ROI because you can get that right now from a REIT or banking stock dividend).

Last night I did some hasty calculations and decided that I shouldn’t have bought my PEB shares because all the possible success is already priced in and my purchase was essentially a Greater Fool scenario and I was looking like the greater fool. Consequently I sold my small parcel of PEB shares today, and I was lucky enough to get what i paid for them (less brokerage fees). I don’t recall exactly how I arrived at that conclusion, but for the sake of my sanity, lets run some numbers to confirm that this was the right thing to do.

Based on the current Market Capitalization (MC) of $551 ($525m current MC + 5% for the upcoming dilution of stocks to be created for ANZ’s purchase), PEB would have to sell X Cxbladder tests to justify that MC, based on theoretical NPAT being 20% of revenue, and at a multiple of NPAT of 25 because they’re currently growing (we can reassess the basis for that multiple later if required).

To find the value of X (the number of tests needed to be sold to justify the current MC), we take the adjusted MC of $525, divide by 25, divide by 20, multiply by 100 and then divide by $760, which gives about 138,000 tests. If you want to follow the logic of that, I arrived at that formula by rearranging the formula to calculate NPAT as (revenue / 100) * 20, revenue was defined as number of tests multiplied by the cost of each test ($760), and MC = NPAT * 25.

138,000 tests is a lot of tests per year, given that the US market may be somewhere between 300,000 and 500,000 tests per year. Also given that it’s approaching market saturation (assuming that they don’t get all the business in the US – maybe they just get 50%, which would be a lot!), you could argue that target ROI should be a dividend of 10% of initial investment, at least! This would at best be a multiple of 10 instead of the multiple of 25 that I used. So realistically, to justify the current MC, PEB would have to sell about twice that number of tests within the next year or two.

I also looked into the size of markets in other affluent English speaking countries and decided that these were negligible compared to the US. For example, in the UK my research showed that they have only ~10,500 new cases of bladder cancer, which would equate to a requirement of about 50,000 tests a year (10% of the US market). Additionally, stats show that instances of bladder cancer are decreasing in the UK, though the articles I read didn’t say why that was.

In summary, I think that Drcjp of ShareTrader was correct (thank you very much, if you’re reading this). I shall try to be more careful next time and stick to less speculative investments that give me more comfort around my long term investment strategy and try to avoid Greater Fool investments.