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This article will serve as the basis for a series of articles showing why many of today's bubbles, including Salesforce.com (NYSE:CRM), Netflix (NASDAQ:NFLX), Tesla (NASDAQ:TSLA), Amazon.com (NASDAQ:AMZN) and others are, well, bubbles. This article will provide the logical foundation and explain what's wrong with the way these stocks are valued. The articles that follow will provide concrete examples.

The Fallacy

The one thing to understand about any company is that we don't really know the future. For instance, Nokia (NYSE:NOK) was once selling paper products, tires and footwear. Then it got to be the world's mobile phone leader, then it imploded due to Apple, then it sold its mobile phone division for what was at the same time good money, and a pittance (if we look at its glory days). We simply cannot really predict the future, a lot of different things can happen.

Since we don't know the future, lots of different scenarios can happen down the road. Some more likely to happen, some less likely to happen. It is here that the typical research goes haywire when valuing a bubble stock. Typically, what happens is that the analysts focus on a possible, but unlikely, outcome as if it were the most likely outcome. This possible, but unlikely, outcome is then basically valued as if it were a certainty.

This is helped by the most often used tool for valuation, the discounted cash flow. A discounted cash flow model takes a series of future cash flows and discounts them to the present to arrive at a valuation. It asks mightily for a single scenario to be discounted back.

Cash flows are thus produced far into the future reflecting the happening of this very favorable outcome, and then they are discounted to the present day. This, more often than not, justifies valuations that seem highly speculative today. This is the way analysts can slap a buy on Salesforce.com or Amazon.com at more than 100 times forward earnings, and more than 200 times past, realized, earnings.

Said another way, analysts take something very favorable which could happen, and discount it back from the future as if that something were a certainty. Thankfully, there is a way to visualize this.

A lottery

Think for instance about a lottery. In this lottery, a ticker originally costs $1, has a 1:1000000 chance of winning, and the prize is $1 million. At inception, the ticket is fairly valued (if we ignore time value).

Now, remember, this ticket could pay out $1 million. So the analyst goes and says, "I think the ticket will pay out $1 million", and suddenly, any price below $1 million is cheap, because the ticket could pay it out.

The problem, of course, is that although the outcome of the ticket paying out $1 million is possible, it's also incredibly unlikely. But at the same time, drawing attention to that payoff allows one to incredibly overvalue the ticket, calling it cheap at $1, $2, $10, $100 … because after all, it could pay off $1 million.

The same thing happens over and over with stocks. Stocks get valued on unlikely "fairy tale" scenarios which the companies have not yet shown capable of attaining. Obviously the future, like the drawing of that lottery, takes time to arrive, and in the meantime great amounts of money can change hands.

But in the end, more often than not, the ticket pays no prize. And the same thing happens to those stocks whose giant multiples get built upon dreams of an unlikely future.

Conclusion

The basic fallacy that allows nearly every bubble to build up to unimaginable heights is nearly always the same. It consists of discounting a very unlikely, but highly favorable, outcome as if it were a certainty. This dynamic is helped both by conflicts of interest in investment banking and the basic tools used to value companies, namely discounted cash flows that rely on a single central scenario instead of the expected value of many different, possible, outcomes.

In my following articles I will explain, for several stocks, what could happen differently. We will see that for each, it is possible to think of an alternative outcome whose value is much different from the central bull thesis driving each stock.

Source: The Basic Fallacy In Momentum Stock Analysis