If you have to be human and get a little bit caught up in a stock market that has been on a very steady advance for 6+ years, find a trendy stock that at least bears some kind of relationship between the price you pay and the current earnings that support part of the valuation.
Paying $735 for Alphabet (GOOG) stock may be overpaying, but for someone with a 5+ year time horizon, it isn’t stupid. It makes $21 billion in profits and has a $500 billion market cap. That’s 24x earnings. You won’t get killed on your investment doing something like that. The realistic case scenario is that the business grows profits by around 13% per year, sees the P/E ratio come down in the range of 20, and you get something close to 11% annual returns for the next five years. Your protection is the fact that there is already a whole lot of profits being generated right now, and those $21 billion profits have been and continue to grow at a very fast pace.
But Facebook, which is now hovering around $120 per share, has absolutely no historical precedent suggesting that an investment on these valuation terms will have any chance of creating wealth. Facebook is being valued at $340 billion while only earning $5 billion in profits. That P/E ratio of 70 for a very large company spells anything from disaster to mediocre returns. Just as someone buying Coca-Cola in 1998 has only earned 3% over that time despite the business growing earnings at a 10.5% annual rate and paying out a growing dividend amount every year as the P/E ratio compressed from 70 to 20, there is no almost no way that Facebook investors have a chance of performing near a plain old S&P 500 Index Fund over a decade-plus time horizon.
Anytime you are tempted to purchase a large company at a nosebleed P/E ratio, stop what you are doing and read the April 19th, 1999 editorial by Jeremy Siegel in the Wall Street Journal. It’s titled “Are Internet Stocks Overvalued? Are They Ever.”
The whole article is worth a read, but these are the three paragraphs I find the most useful in Siegel’s analysis:
“My reluctance to pay 700x earnings for AOL is not at all because I am a value investor seeking low P/E ratios. In my book, I rejected the conventional wisdom that the Nifty Fifty of the early 1970s–those high-flying stocks that carried an average P/E ratio of 40–were overvalued. Even from their market peak in December 1972, many of these firms, such as Philip Morris, Pfizer, Bristol-Myers, Gillette, Coca-Cola, Merck, American Home Products, and Pepsi, outperformed the S&P 500 over the next 25 years. But none of the firms that outperformed the market had a P-E ratio in excess of 60 in 1972, and even the most deserving stock of the original group, Coca-Cola, would have been overvalued at a P/E ratio of 80.
Even stocks that seemed to have an impregnable hold on future technology did not warrant P/Es in the triple digits. IBM is an example. Although Remington Rand came up with the first computer, Univac, in 1951, IBM soon dominated the field. With its superior research, development and marketing, IBM captured nearly 80% of the computer market in the 1960s and 1970s and its brand became almost synonymous with computers and high technology. IBM reached an unheard of 65 P-E in 1961.
But despite IBM’s spectacular earnings growth of 18% a year for more than 15 years, IBM was overpriced at that ratio. Big Blue underperformed the S&P 500 after its market peak in 1961 In fact, none of the technology stocks in the original Nifty Fifty (including Xerox, Digital Equipment, Texas Instruments, Burroughs, Kodak or Polaroid) has managed to outperform the index over the past 25 years.”
In short, if you own shares in a fast-growing large business–be it Visa, Nike, or Google–it is foolish to overmanage the position and get worried when you see the P/E ratio drift above your comfort zone into the high 20s. The growth rate is still so high that even after adjusting for what you lose from P/E compression, you will still end up with great if not spectacular long-term returns. But as large companies see their normalized P/E ratio pivot towards 40x earnings and beyond, the anchor created by that high starting valuation becomes such an eventual drag that future earnings growth won’t enable investors to benefit from the company “growing out of” its overpriced territory.
Originally posted 2016-06-04 23:59:08.