On April 7, 2014, I published an article on six stocks for a market sell off with this snapshot of their movements on Friday, April 4, 2014, and suggested it might be just the beginning. The stocks were Tesla (NASDAQ:TSLA); Netflix (NASDAQ:NFLX); Facebook (NASDAQ:FB); Workday (NYSE:WDAY); Salesforce.com (NYSE:CRM); and, Twitter (NYSE:TWTR).
Sometimes the sun and stars line up. By and large the six names have all stayed in the red since last Friday with deepening losses in most cases. All remain good short candidates for a continued market downturn.
The reasons why these are good shorts haven't changed in a week. They have a long way to go before they reach "buy" territory. The recent pullbacks are likely the beginning of a correction to bring the momentum names a bit closer to their real value.
But what is their real value?
For the companies growing but yet to turn in meaningful profits the valuation challenge is severe. They can have very high revenue growth and nothing but the prospect of future profits, so how to value them is an issue for those wishing to invest. There is an excellent paper by A. Damodaran (Stern School of Business, May 2009) which provides some insight and includes the conceptual framework set out in the graphic below:
Source: Aswath Damodaran Valuing Young, Start-up and Growth Companies: Estimation Issues and Valuation Challenges, Stern School of Business, May 2009.
Damodaran provides an insight into the failure rate of new businesses which should give investors pause as they approach the issue in chart reproduced below.
What's more, the price to earnings ratios of momentum stocks can be all over the map but rarely stay in the stratosphere for very long.
From a trader's point of view, it is easier to assess whether a fast growing stock is overvalued than to assess its actual value. You can estimate a high value for the rapidly growing but largely profitless stocks by imputing a high level of profitability and a high rate of growth and see if they stand the test of being measured like any other company. If the stock market is overvaluing them by any substantial amount, it will be evident when you give them the benefit of all doubt and find their inherent potential worth much less than the market has assigned.
It is an old rule of thumb (backed by quite a bit of financial analysis) that the valuation of a corporation using a multiple of earnings comes close to most valuation methods if the multiple of earnings is more or less equal to five plus the sustainable rate of growth for companies growing between 10 and 30% a year although multiples get a bit out control when growth exceeds 30%.
A study by Saxo Bank Equity Research lends some empirical support to this rule of thumb. The chart shows price earnings multiples versus growth rates based on actual market data. It does not suggest the multiples were warranted or that investors paying high multiples made out.
Source: Peter Garnry, Head of Equity Trading, Saxo Bank
Using my rule of thumb, a fast growing company growing at 30% annually would be valued at 35 times "normalized" earnings. By "normalized" I mean earnings capacity rather than actual earnings since in the early stages of growth, earnings are frequently sacrificed to the costs of putting in place the means to sustain growth.
For most technology businesses, earnings after taxes equal to 20% to 25% of sales are at the high end of reasonable expectations. Look at a few examples.
Source: Company income statements
Growth rates are compound and very fast growing companies find they cannot sustain extremely high growth for very long. A company growing at 36% annually doubles its sales every two years. A $1 billion company with a 36% growth rate would be a $128 billion company in less than 15 years. Only ten of the Fortune 500 companies had sales in excess of $128 billion in 2013.
The expectation that each fast growing company can sustain that growth for an extended period of time is likely to meet reality long before 15 years pass. As a result, except for relatively small companies, earnings multiples of over 35 to 40 times are generally unwarranted and produce unhappy investors as time goes by.
Using the earnings multiple approach to what I have called "normalized earnings" for the six companies reviewed produces the following table. I have assumed some "sustainable growth rates" and imputed net income after taxes at a flat 20% to sales for all companies except Netflix where, owing to high content costs, I judged a 10% after tax return on sales was more representative.
Source: Blair analysis
Using Workday as an example, if you project this company to grow at 40% rate for many years and assume it will earn 20% net income to sales, you find it has a "value" of $6.62 billion based on an earnings multiple of 45 times, equal to about $35.95 per share. However, the market says Workday is worth $73.62 a share based on the stock's April 10, 2014 closing price. It should be plain and obvious that Workday cannot reasonably be worth $70 plus a share unless it has truly remarkable growth prospects that far exceed 40% annually or can earn net income to sales substantially greater than 20% after taxes. Both are unlikely, and I conclude this stock is overvalued by half.
Applying a similar approach leads to per share "values" for each company well below current stock market valuations.
To many this analysis will seem superficial. But the fact is, the future growth of the entities is not known; their future profitability is not known; and, the degree to which they can sustain growth for an extended period is not known. What is known is basic arithmetic.
The arithmetic gives you a way to express your enthusiasm for a stock in a more formal way. For example, an investor buying Workday today at $73.62 a share should be saying: "I believe Workday can grow for many years at a rate much faster than 45% and am confident that it will earn net income to sales in excess of 20% after taxes, so I am bullish on the stock."
If you can say that with a straight face, put your money on the line and go baby go! If it does not work out you can always use it as a tax loss.
I have traded in and out of these names for a while now, and currently am short only CRM of the group. The recent sell-off in the market has led me to take some profits and wait for a bounce to re-establish my shorts. In the case of CRM, it is my view the company has no hope of ever earning anywhere near 20% net income to sales and the growth is more smoke and mirrors than customer enthusiasm for its offering, at least in my opinion.
Good luck with your investments.
Disclosure: I am short CRM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.