For many investors, realizing the importance of valuation, looking beyond price, is a key epiphany. Valuation is very important, but can also be tricky. For example, consider how many people have forsaken stocks like LinkedIn and Tesla due to their Price to Earnings multiples (high for LNKD and “does not compute” for TSLA). Yes, current prices are high relative to earnings for these stocks. However, price and even valuation itself can be relative.
For example, Google had earnings per share of $0.41 in 2003. When the company went public at $100 in 2004, it had a trailing P/E of over 200 times. To many GOOG seemed expensive then. Today GOOG trades at $855 and has EPS of $35.66 (trailing twelve months). That yields a P/E of about 25 times. Despite an eight-fold increase in price, GOOG’s valuation now looks 8 times less expensive! This was because Google’s earnings growth was even more spectacular than it’s price performance, shown below.
Of course not every stock can be like Google. Yahoo, for instance, is still down 70% from its highs reached in 1999. And the truth is the market has seen more “yahoos” than the likes of Google.
I’m not trying to endorse LinkedIn or Tesla, I’m just pointing out that a stock shouldn’t be written off simply because of a high P/E multiple. Investors that did so when Google was at $100 are probably still hating themselves for that today. New businesses in emerging industries can deliver incredible earnings growth. In that sense, a high P/E just isn’t the same death sentence that it might be for a mature company in a slowing industry.
The bottom line is while valuation is a useful tool, it needs to be applied carefully. Beyond coming up with simple multiples, we should ask why they are so, look at underlying assumptions, and evaluate whether or not they are reasonable.
Victor K. Lai, CFA
This blog is for informational purposes only. Nothing on this blog represents advice. Investing is inherently risky and involves the potential for loss. Victor Lai does not own any of the securities referenced in this posting. Clients of Bellwether Capital Management LLC may own shares of the securities referenced in this posting.
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