If you turn on a television, the types of companies that you typically hear about are Tesla (NASDAQ:TSLA), Netflix (NASDAQ:NFLX), Amazon (NASDAQ:AMZN), and so on. It's easy to understand why they command a lot of attention. Roughly this time last year (April 18th), Netflix was trading at $161 per share. Now, the company trades at $334 per share. On May 1st, Amazon was trading at $245 per share. Now, it's at $317 per share. For Tesla, the results are even more eye-popping: the company traded at $40 per share this time last year, and now the stock price is at $200. Looking at the sharp arc of Tesla's stock price, and combining it with the fact that I saw Third Eye Blind perform live last week, it's starting to feel like 1999 again.
But here's the thing: a stock price advance doesn't mean anything in terms of sustainability without connecting it to: (1) current profits, and (2) future profits.
For Tesla, the company is expected to earn $1.55 over the course of 2014. That works out to a valuation of 131x current profits. The problem is that, over the long term, a fast growth company has a strong tendency to reach an equilibrium P/E ratio in the 20-25x profits range. The headwind of P/E compression for something like Tesla will be substantial.
The most optimistic five-year forecasts for the company anticipate that Tesla could be making $5.65 per share in 2019. What happens if the company's valuation normalizes to something in the 20-25x profits range? Tesla stock will then trade somewhere between $113 and $141. Even if profits advance from $1.55 to $5.65 per year in the next five years (and that's a heck of an optimistic assumption, because it works out to 33.41% annual growth), current investors are still looking at severe contraction in the P/E ratio. The current valuation is so out of sync with current business fundamentals that even projections of absurdly high five growth cannot come close to justifying a breakeven scenario.
The case of Netflix tells a similar, albeit less extreme, story. Over the course of 2014, analysts anticipate that Netflix will post profit figures of $3.50 per share. At the current price of $334 per share, that works out to a P/E ratio of 95x earnings. The optimistic five-year projections for Netflix have the company posting profits of $7.50 per share when 2019 comes around.
If Netflix follows the habit of large-cap companies to eventually end up trading in the 20-25x earnings range, then the price of Netflix stock would fall to $150 to $187.50. Even if the company's core business performs well (the assumption in the $7.50 is that Netflix will grow profits at 16.47% annually for five years straight), the negative changes that Netflix will experience from a normalizing P/E ratio will be so substantial that fast growth will not produce satisfactory results.
With Amazon, the company's story is always the same: expected earnings per share is right around the corner. That's been the storyline for five years now, but at some point, you would think that investors would recognize that Amazon gains market share by keeping its profit margins exorbitantly low (in 2014, the net profit margin for Amazon was 0.4%). The last time that Amazon had a profit margin above 1% was 2011, when the company maintained a 1.3% profit margin. That's a component of the company's moat, and if Amazon tries to increase margins to goose profits, the risk of market share loss would increase (that's the danger of having low-cost services be part of your business moat).
In 2014, Amazon is expected to make $1.85 in profit (this is less profit than Amazon earnings during the financial crisis, as Amazon reported earnings per share figures of $2.04 in 2009). At a current price of $317 per share, that works out to a P/E ratio of 171 for 2014's expected profits.
Amazon is already a $145 billion company. When the company's P/E ratio falls in line with other megacap companies in the 20-25x profits range, it will be a painful experience for shareholders. With Amazon, the most optimistic five-year profits are that the company will earn $10 per share in 2019. In other words, a quintupling of profits within 5 years (something I'd classify as quite unlikely because it projects 40% annual profit growth).
But yet, even if it achieved that kind of growth, a 20x earnings multiple would value the stock at $200 per share and a 25x earnings multiple would value the stock at $250 per share. You're not engaging in prudent investing when even 40% annual profit growth for five years would still lead to a share price. I'll put that in other words: for Amazon investors to break even over the next five years, they would have to achieve both 40% annual profit growth and a valuation of 32x earnings for the stock.
When these widely touted stocks don't pan out as investments, you often hear people complain of things such as "The market is rigged" or "there's no way for the little guy to make it." No, that's not the case at all. Tesla, Netflix, and Amazon won't work out well as investments because the nexus between the current stock price, current profits, and future profits ensures mediocrity.
With these companies, you need to put a tag on what you believe their long-term valuation will be. The conclusion I reach is that, based on Benjamin Graham's research, it is very unlikely that large companies can maintain P/E multiples above 20-25x profits for the long run. The implication is that reversion to the mean will be a powerful principle with these companies because even projections of superior growth over the next five years will not be enough to offset the harm caused by P/E ratios drifting from 100x earnings to 20-25x earnings. The valuations of these companies are reminiscent of a 1990s fantasy land. Companies with valuations of 100x earnings should not be part of your portfolio strategy. The circus is the same, but the clowns are different.
Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. 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.