Company Valuations – Why is a Stock Worth That Much?

Ultimately, the value of any item is what others are willing to pay for it. In the absence of government intervention, prices are set by supply and demand. Consumers typically decide what they are willing to pay for an item based on their tastes, preferences, philanthropic values, or sentimental attachment. However, the price an investor is willing to pay for financial assets such as stocks or real estate is based on the present value of expected future earnings.

Let’s say two companies each earn $1 million. One company may be valued at $20 million (20x earnings) and the other at $40 million (40x earnings). Why? The answer is expectations about future earnings growth. This is why IBM’s shares are currently valued at 13x earnings and the much faster growing Apple Computer is valued at 35x earnings. This makes sense, right?

The question is: How do you value a company that has little or no earnings?

The answer is: You speculate or guess how much the company might make someday. Sound risky? It is. Many people thought Google was crazy when it paid $1.65 billion to buy YouTube in 2006 when YouTube had no earnings. That turned out to be a great investment. The same cannot be said for companies like Webvan, Global Crossing, and CMGI, all of which had sky-high valuations, based on overly optimistic assumptions about their prospects. Sadly, they all went bankrupt when their business models did not pan out.

As you may recall, in March of 2000, the dot com bubble burst. There was too much money chasing too few good ideas, and valuations had become totally divorced from reality. The entire S&P 500 was trading at an average of 35x earnings, well above the historical average of 15x. The question we frequently ask is: Is that happening again? Overall, the S&P 500 is still at a somewhat reasonable valuation, but there are signs that investors in some sectors are getting carried away.

Current Valuations

The chart below shows that stocks of all sizes and styles are trading a higher price relative to earnings than they have on average over the past 20 years. This is partially justified (and expected) based on our current extremely low interest rates environment.

Source: FactSet, Russell Investment Group, Standard & Poor’s, J.P. Morgan Asset Management. All calculations are cumulative total return, including dividends reinvested for the stated period. The price to earnings is a bottom-up calculation based on the most recent index price, divided by consensus estimates for earnings in the next 12 months (NTM), and is provided by FactSet Market Aggregates. Guide to the Markets – U.S. Data are as of September 30, 2020.

Irrational exuberance?

One valuation example that has many veteran stock analysts scratching their heads is Tesla. This company makes a world-class product, has devoted customers, and has a huge potential market. In addition, it is making massive investments in new battery technology. That being said…the stock trades at more than 1,000x earnings.

Tesla was the 4th most valuable automobile manufacturer in the world as recently as March 2020. In just the past few months, its valuation has passed all its competitors to become the most valuable car company in the world. In fact, it is more valuable than the next 3 competitors combined (Volkswagen, Toyota, and Daimler/Chrysler)! To put that in perspective, Tesla produced 400,000 cars in the last year, whereas their three largest competitors produced 24,000,000 cars.

Final thought: Great companies do not always make great investments. Eventually, valuations matter.

Questions, thoughts, comments? Send us an email.