Why Your 'Gut Feeling' Probably Is a Stomach Ache

by: Mitch Vine

Many people like to invest in companies because of a “gut feeling” - a belief that seems to them like common sense. “Every time I shop at Ripco, the parking lots are full. They’ve GOT to be making money." “Electric cars are the future – a company making battery technology can’t miss." Here’s another favorite: “Widgit Co. has dropped from $50 to $5 in the past six months. It’s got to be a bargain!”

Often these people have no idea what price they should pay for the stock. “Google (NASDAQ:GOOG) is a great company.” OK, does that mean you should buy the stock at $600? What about at $1,000 or $2,000?

For most people, doing a valuation of stock price is beyond their experience. They want to invest in stocks, but they have no way of knowing whether the stock is overpriced or underpriced. Perhaps they just assume the stock will go up forever if they just hold on long enough. Or perhaps they just take advice from industry analysts.

Stocks in the development stage are particularly hard to put a value on. The few analysts following the company may have a lot of bias. They may have to rely too much on glowing company forecasts for valuations.

Ratios are often used to do a rough check. “P/E is already 35 to 1” or “price to sales is a low 3 to 1." But these are awfully crude tools unless you know what is behind them. A power utility with a price to sales of 3:1 sounds very expensive, but a technology stock with a 3:1 price to sales ratio may be a bargain.

We like to focus on smaller technology companies that have the ability to grow rapidly and provide a big upside. We’ve developed a model that takes basic inputs: Current revenue, revenue growth, net profit predicted, cash in the bank, and a screening check on a stock.

Here’s our example of the day: A123 (AONE) is an advanced battery manufacturer. The company, like many battery manufacturers, has been a darling of the alternative energy set. Several battery companies like A123 have gone public and are trying to build the batteries of the future, often to be used in electric cars. The risk, pointed by several authors, is there may not be enough demand in the next 10 years to justify the number of new battery companies.

Other companies in the battery sector include Altair (NASDAQ:ALTI), Axion (AXPW), BYD Co. (OTCPK:BYDDF), EnerSys (NYSE:ENS), Ener1 (NASDAQ:HEV), Johnson Controls (NYSE:JCI), Tesla (NASDAQ:TSLA), Valence (VLNC) and Exide (XIDE).

Most of the battery manufacturers have been beaten up badly in the past year. AONE’s stock price has dropped from $9.86 to $5.50 since the beginning of the year. Is the stock fairly priced now?

AONE generated $90 million in revenue in FY2010. It lost $152 million in net income, and had about $226 million in cash. We “played” with our model just to see what amount of future revenue growth and profits would justify their current $ 5.50 price.

Here are some rough assumptions we’ve made:

  • Revenue grows 25% per year for the next 12 years
  • Net Income is 0 in FY2011 and FY2012 (likely optimistic based on recent experience)
  • Net Income will average 15% of revenue for the long term (starting in three years)
  • Cash and debt remains roughly the same.

Plugging numbers into our prediction model, we would just barely justify pay $5.50 for the stock.

Do these assumptions sound likely? What does 25% growth mean? For the next 12 years revenue would need to grow from $90 million to about $1.3 billion. Also, is 15% net profit possible? That’s been done by many technology companies, but could be challenging given that AONE could be selling to a relatively small number of buyers who have strong negotiating power.

Alternately, we could assume that

  • net profit will “only” reach the 8% level.
  • revenue would have to grow at the 35% level for 10-12 years (reaching about $3 billion in revenue) to justify a $5.50 price.

We don’t know this industry well enough yet to judge if these assumptions are reasonable, however these kinds of numbers have been achieved before by industry leaders in other high growth segments. Is AONE going to be an industry leader? Will demand grow quickly enough to allow a leader to generate $3 Billion in revenue in the 12th year?

Time for you to be the judge. But with a simple fundamental model, at least you have some sense that your gut feeling is backed up by the numbers.

Disclosure: I am long GOOG.