Does Valuation Matter?

I always wonder about this valuation thing - at times it simply seems all that matters is what people want to buy (relative strength) and valuation means nothing. Case in point, I'd like to show you two stocks.

#1 is a fund holding we've had for a long time - Illumina (ILMN). I never have it as a major position - it usually sits around 0.5% to 1.25% of the portfolio because I always think it's "too expensive". I rarely talk about it other than around earnings. I've been watching it act incredibly well during this correction - living in its own universe. It's not sexy and it never makes our "top gainers for the week" but the chart over the long run is fantastic. Valuation? Ridiculous. Forward P/E ratio of 75 on $1.20 of 2008 full year estimated earnings. That doesn't matter - all it does is go up. [Dec 20: Nice Writeup on Illumina]



#2 is a tech stock I've tried to short multiple times in my personal life over the years (and lost money every time I am sure) as it's always traded at 100x+ forward estimates! Yet it always stays at some amazingly nonsensical (to these eyes) valuation - Salesforce.com (CRM). Valuation? Ridiculous. Forward P/E ratio of 200.



When I was looking for a new tech stock to add to the portfolio this was far and away the best chart but being a "growth at reasonable value" guy at heart, every other name I considered was trading at a PE multiple BELOW it's growth rate. Yet CRM has outperformed every other one I considered. And this folks is why the market will pummel every rational brain cell from your body the longer you stick around.

I do realize these are somewhat unique companies but gosh - those are some steep valuations. But at times it simply pays to stay onboard as long as the whales keep wanting to eat this type of fare.

Disclosure: Long Illumina in fund; no personal position

Comments

[Eric Fox]

In the long run nothing is more important than valuation, but as you correctly stated momentum can carry a stock for a long time. Both these stocks can go a lot higher. It's too bad oil doesn't have a PE ratio, then we end the debate on its fundamental worth.

[rickf]

Frankly given the shaky data that 'analysts' and pundits base their reports and recos on, I think fundamentals and 'value' numbers are fairly meaningles. The past year it's been all about emotion and psychology, not value -- meaning momentum is key. Great stocks can get pummelled into submission because of traders' emotion, not because their 'value' suddenly changes....to that end since last year I've taken any report of 'valuation' or 'cheap' or 'expensive' companies with a BIG grain of salt, because in many cases, the numbers can be fudged rather easily to sustain a few more weeks of price buoyancy. (*cough* BSC, CFC, BAC, UBS, MER, LEH, et.al) With fundamental data being demonstrated as questionable in many of these companies, I really think it's idiotic to place much faith in 'value' calls on a company's numbers. I mean, LEH, C, and UBS may be considered 'value' stocks now but I wouldn't touch them with your money, let alone mine.

Similarly -- the mere fact that 'analysts' and 'rating agencies' still have generally-safe ratings on the mortgage firms (clearly a meaningless rating @ the moment) tells you all you need to know about the concept of 'value' and 'safety' in the market.

The other commenter is correct - it's all about momentum at the moment. P/E, fundies, and such just, in my view, don't matter these days. Perhaps interesting to learn as part of trading homework, but a firm's "valuation" wouldn't be more than 30% of my decision to enter a trade.

[DavidHamilton]

"But at times it simply pays to stay onboard as long as the whales keep wanting to eat this type of fare."

Sure, there's always another, greater fool waiting down the line to take it off your hands -- until there isn't. Did people really learn nothing from the dot-com bubble? The moment otherwise intelligent people start to get sucked in by this sort of market -- or individual stock -- psychology is the moment to sell.

[jjason]

Do these firms pay dividends?

[jlounsbury59]

You can not value a stock without making an estimate of future earnings. The true value of a stock is the present vale of all its future earnings discounted to today. In the long run, all stocks will time average to a true value.

The fly in the valuation ointment is the estimation of future earnings. At best, it is an educated guess. At worst, it is a dart board.

Thus, enter momentum. If one has a nimble strategy with good loss prevention techniques, one can far outperform a successful value investor with momentum trading. I believe the truly great can combine value investing with momentum strategies.

[licketysplit]

"the market can stay irrational longer than you can stay solvent"

[Jack Yetiv]

Mark, nobody can dispute your examples.

BUT, Warren Buffet is not considered the best investor of all time by following the above belief.

He is the best example of "value" investing there is--and he has done pretty well over many years.

I'm with Warren on investing style.

Jack

[Levan]

"Valuation, valuation, valuation" is the way for fundamental analysis and stock price is represent for the company business worth.
If you find out the current stock price greater than its intrinsic value or company discount future value; then you the price you is looking at is a momentum value by human emotions - greed & fear.

[Eric Fox]

rickf..you said "The past year it's been all about emotion and psychology, not value -- meaning momentum is key."

It seems that it is always about this.

Also, you are assuming that valuation always has to do with earnings and since you have no faith in analysts or company management then you have lost faith in value investing. Valuation can be based on assets as well. All the stocks you mention looked "cheap" because the book value had not been updated and since the price had declined they seemed "cheap." Many of them were also extremely leveraged - another thing that value investors avoid. The lesson - just because a stock is down 50% does not make it a value stock or a good investment.

[H.J. Huney]

I agree 100% with David Hamilton's comment above.

Valuation still matters in the long-run. Stocks can run on momentum for a long time, but eventually, if the price is based on nothing but thin air, the roof is going to collapse. The tech bubble collapse in 2000 demonstrated that rather nicely.