By Michael Johnson
There are currently two entirely different stratospheres between tech stocks. The first stratosphere represents a group of companies that are trading at low earnings multiples, have impeccable balance sheets, and have a long history of earnings growth. The second stratosphere represents a group of companies trading at sky-high earnings multiples or fail to make any money at all and are overhyped with investors eager to get a piece of the next big idea.
The same companies (with the exception of Google) that once got crushed during the tech bubble implosion are ironically some of the most undervalued components of the S&P 500 today. They are all cash cows and appear to be very undervalued by the investment community, because they offer steady cash flows and huge cash stockpiles, rather than the next big idea.
On the other end of the table sits a group of tech stocks that possess the same characteristics as most components of the Nasdaq prior to the collapse of the tech bubble. The main argument for bulls in favor of these stocks is that the reason they are so expensive is that they are factoring in future growth. I do not doubt that these companies will grow moving into the future, but they will have to not only grow, but surpass the market's current expectations to justify their current valuations.
Forward P/E (1 yr)
PEG Ratio (5 yr expected)
I've said it before and I will say it again - Apple is a screaming buy at $430 per share. Its trailing P/E of 9.77 and $137 billion pile of cash implies that the market is pricing Apple like a distressed asset, rather than a highly profitable cash flow machine. Analysts may be a little overly optimistic with their 5 year annual growth rate estimate of 18.98% over the next five years, but Apple does not have to achieve anywhere near that kind of growth to justify its current stock price.
Google is perhaps the least attractively priced stock in out of the large cap tech behemoths I have mentioned, but quality also commands a premium and Google is perhaps one of the best run companies in the world. Since Larry Page has taken the reins as CEO, Google's share price is up 55% and the company has transformed itself from purely a search engine to a company that dominates the smartphone market, with 70% of market share through its Android operating system. Android by itself does not generate much revenue for Google, but it helps contribute to the overall profitability of the company by giving Google more information on its Android users, thus making Google's advertisements more valuable. All of this has helped Google grow revenue like a start up with year over year revenue growth of 36.2%. Another reason to be bullish on Google is that unlike many other tech companies that need to release a blockbuster product every new product cycle in order to remain profitability, Google receives the overwhelming bulk of its revenue from search, which is reoccurring revenue and something no one has been able to do an effective job of competing with Google.
Microsoft offers recurring revenues from its Windows products and even though it appears to be behind the curve in its mobile presence, it essentially has a monopoly on the PC market that isn't going away any time soon. IDC estimates that overall PC shipments will grow by 1.9% per year until 2017, led by an 18.3% increase in portable PC shipments, with the bulk of the increased demand coming from emerging markets. 1.9% annual growth in PC sales may not be the kind of growth rate to make Microsoft a growth stock, but with forward P/E of 8.86 and nearly 30% of the share price consisting of cash, I am willing to bet on the new Xbox and Windows Mobile operating system to sustain future growth.
Cisco is also a great deal at its current valuation, with a trailing P/E of 12.54, forward P/E of 10.35, and $46 billion in cash sitting on its books, I see few things that can go wrong for Cisco. The $46 billion in cash sitting on the books represents nearly 40% of the overall market capitalization of the company and gives it a lot of flexibility moving forward in regards to making acquisitions or increasing the dividend going forward.
Oracle offers investors a growth stock at a value price, with a forward P/E of 12.11, a PEG ratio 1.10, and a price to sales ratio 2.46. I am not the only one who sees value in the stock and it is currently the third largest position in Baupost Group's portfolio, according to their most recent 13-F. The firm is headed by value investing icon Seth Klarman and at Oracle's current valuation investors can be certain that the stock offers investors a Margin of Safety.
Forward P/E (1 yr)
PEG Ratio (5 yr expected)
Note: I am placing AMZN in new tech rather than old tech because it is a completely different company than it was before the tech bubble collapsed and shares many characteristics with the other stocks in that group.
Amazon is the epitome of an overhyped growth stock. I love the company and in actuality, I use its service all the time. More often than not the company has the best price, which is very convenient for someone like me who hates to do comparative shopping. However, I cannot say the same thing about the stock. I believe its current valuation prices the stock far beyond any realistic expectation of future growth. Even if the company does manage to get back to profitability, it is in an industry that is plagued by paper thin profit margins and Amazon cannot raise its prices to remedy this situation, without losing some of its competitive advantage.
In all fairness to Facebook, it was a much better illustration of the word "bubble" at $45 than at $28, but I'm still not sold that its growth prospects justify its current valuation. Its trailing P/E of 1874, forward P/E of 35.54 (I'll believe that when I see it), and price to sales ratio of 13.09 lead me to believe that Facebook is far from a bargain. A price to sales ratio that high typically implies that a company is experiencing rapid growth and is highly profitable. Facebook is neither of those things and it is arguable that the company is reaching a saturation point.
LinkedIn is another company whose product I love and stock I hate, especially after its recent run up. LinkedIn is an expensive stock by almost every valuation metric I can think of, with a trailing P/E of 922, a forward P/E of 84.75, and a price to sales ratio of 19.84, I would avoid this overhyped growth stock at all costs. I'm not saying that there is not some possibility that LinkedIn can blow away analyst estimates and justify its current valuation, but what I am saying is that LinkedIn is far from a bargain and investors that enter at its current price point are taking on a significant level of risk in hoping the company to meet the market's sky high expectations.
I have been using Pandora since 2003 and I love its product. However, yet again I cannot say the same thing about its stock. It is ultimately another unprofitable company that trades at 75 times forward earnings and I cannot justify paying that multiple for growth, when there are plenty of quality blue-chip tech stocks that offer growth at a reasonable price. Furthermore, with increased competition from the likes of Spotify and Songza, it remains to be determined if Pandora can maintain its current growth rate indefinitely into the future, which is exactly what it needs to do in order to justify the company's current valuation.
I see no realistic series of events that can justify Zillow's current valuation. The stock has a trailing P/E of 287, a forward P/E of 65.32, a PEG ratio of 4.79, and a price to sales ratio of 14.43. These valuation metrics scream "bubble" and I see no reason to pay this much for growth when the market offers plenty of more level-headed alternatives.
Conclusion: Avoid overhyped tech stocks and invest in proven blue-chip tech stocks that offer dirt cheap valuations and growth at a reasonable.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
Business relationship disclosure: This article was written by Michael Johnson, one of our Equity Research Interns. We did not receive compensation for this article (other than from Seeking Alpha), and we have no business relationship with any company whose stock is mentioned in this article.