There is never any shortage of debate when it comes to stock valuations. What is a fair price to pay? When is a stock too expensive? Are current valuations irrational and in bubble territory? Or indeed, can a stock be super “cheap” when the company is loss-making and trading at a price-to-sales (PS) of 10 times?
All these questions are, to a certain extent, subjective. Even if every analyst uses the exact same methodology, the answers will still be different because they all require making assumptions about the future. The task becomes significantly harder for start-up companies during the early years, when their business models are largely unproven and most of them are likely to be loss-making.
There are many stocks in the market today that are trading at jaw-dropping market caps despite not showing a single dollar of profit yet. Some are clearly purely speculative and their high valuations irrational. But to say that of all loss-making companies would be an oversimplification — and plain wrong. Read our article next week for a follow-up on this.
We discussed the basic concept of the valuation metric PS some weeks back. PS has in recent years become the metric of choice for valuing high-growth and startup companies yet to turn a profit. Without earnings (the E), we cannot compute the price-to-earnings (PE) ratio, which is the more traditional and widely used valuation metric. Remember, both are shortcut methods to the discounted cash flow (DCF) valuation methodology. The PS ratio is additionally attractive because it is simple math — just divide the market cap by total sales — and therefore, easy for investors, including the man in the street, to grasp.
As we have said before, a PS of two times does not mean the stock is cheap and a PS of 20 times does not necessarily mean it is expensive. When using the PS ratio to value a company, the key assumptions are the expected sales growth and importantly, if that growth consistently outpaces the increase in costs — that is, margins will improve — so as to translate into profits at some point in the foreseeable future.
The sales growth expectations, which are the justification for high valuations in the absence of profits, must be realistic and sustainable. And for that, investors need to determine the total addressable market (TAM) and the company’s likely share of this market.
One segment of the market where current valuations make no sense is that related to electric vehicles (EV). We wrote about this recently. There has been tremendous excitement over EV start-ups and Tesla. While we agree that electrification is a secular trend and the overall sales growth (demand) for EV will be strong, current valuations implicitly assume that EV players will eat the legacy (internal combustion engine, ICE) carmakers’ lunch. Some investors may genuinely believe this to be the case.
For the tech sector, where new products and new demand markets are being created, the TAM grows from new (additional) sales. Not so for the car market. In the most optimistic scenario, where EV replaces ICE car sales 100%, the TAM is still what it is now. We know the number of cars sold globally, size of the market and historical sales growth. According to Statista, global vehicle production grew at a compound annual growth rate of 2.5% on average between 2005 and 2019 (before the pandemic).
In fact, when cars evolve to become autonomous, fewer will be needed on the road (shared mobility will mean higher utilisation per vehicle) — prices will drop and, most likely, so will the total combined profits of the sector.
In other words, there will not be enough market (sales and profits) to go around, certainly not sufficient to justify the current combined valuations of both EV and ICE players. And we do not believe, even for a single moment, that EV carmakers will outcompete (and replace) legacy carmakers, especially considering the latter are aggressively launching their own EV models. There must be losers in this competition and, ultimately, many will simply go bust, disappear or be merged into larger groups.
The TAM for the auto sector is relatively clear-cut. But in many instances, forecasting TAM can be tricky and twisted to fit the story. Make no mistake, a good story can take a stock far higher than fundamentals can support. Stories sell!
For instance, a super bull for Coinbase Global, the recently listed cryptocurrency exchange platform, could argue that its TAM is the entire market for money (worth tens of trillions of dollars) if cryptocurrencies replace all the fiat money transactions in the world today. The company itself is “less” optimistic, limiting its TAM to “only” the 3.5 billion smartphone owners globally. Yes, it thinks half the world’s population, including every child from birth, will use its platform. That is such a “conservative” assumption, which even professional managers are buying into!
Whether Coinbase is worth its touted US$100 billion ($132.7 billion) valuation depends on one’s assumption on its longterm sustainable sales growth and margins. It is worth bearing in mind that Coinbase currently has very lucrative margins as the premier crypto trading platform. But we doubt it is sustainable. For comparison, existing stock trading platforms have competed all the way to zero fees. We think this will most likely be the case for crypto platforms as well — if and when the business proves to be sustainable enough to attract new entrants. In fact, we are already seeing competing crypto exchanges undercutting each other on fees.
The accompanying table shows the actual financials for Amazon.com from 1995 (the year it was founded) to 2020 and a simple, back-of-the-envelope forecast for the next 20 years. The stock has always traded at rich valuations — perceived and, in fact, based on its high PS ratio in the early years and consistently higher-than-market average PE ratio. Yet investors who bought the stock have been proved right so far — the company’s market cap has grown over the years, supported by strong double-digit sales growth and importantly, with that sales growth translating into profits and cash flow. Marginal cost has trended broadly lower over time. In short, Amazon has successfully grown into its high valuations.
In fact, if we calculate the present value of its earnings for a 20-year period (assuming a set of sales growth and margins, a constant discount rate of 10% and ignoring any terminal value), the stock actually appears undervalued throughout most of its existence — by comparing its historical market caps against our PV calculations.
In other words, the market may have underestimated Amazon’s potential to grow its sales and boost profit margins through the years. We think this can be attributed, in part, to its diversification into the cloud business, from e-commerce retail in 2006 — a very successful move that was only evident in hindsight.
Let us circle back to EV and more specifically, the very divisive debate on Tesla’s valuations. It is the biggest EV player with a market cap of US$717 billion, which translates into a forward PE of 125 times and a PS of 23 times. We do believe the market, in general, is efficient, which means there must be enough investors who believe the company can generate the sales growth and margins required to justify current valuations.
We do not think the math works based on the car market alone — Tesla’s valuation suggests it can sell more cars than the combined sales of Toyota, Volkswagen, Daimler, General Motors and BMW, with the additional assumption that it can achieve the same production efficiency and margins. We bet that Elon Musk knows this too. And this is why he is looking to turn Tesla cars into a ride-hailing fleet to generate a new stream of recurring income (mobility-as-a-service).
No company is static — they reinvest and evolve over time, adding new products, businesses and markets, to continuously expand the TAM and sustain growth. Tesla’s strategy is not dissimilar to how Amazon transformed itself beyond just an online bookseller all those years ago. The US$700 billion question is whether Tesla can grow into its current valuations. Only time will tell. For our part, we are doubtful Tesla has any advantage in the ride-hailing business or, for that matter, in autonomous vehicles. (For a more in-depth discussion on this, please refer to our previous column in The Edge dated April 8, 2021).
Closer to home, on Bursa Malaysia and the Singapore Exchange, we too constantly see companies announcing changes to their business plans according to the flavour of the month, from manufacturing to property to gloves and soon, to digital technologies, presumably. We call these chameleon companies, capable of changing their skin colour when required. And yes, investors must be careful not to be misled by them.
We do, however, think Amazon has plenty of room left to grow — based on what we see today, including the still-nascent prospects in cloud computing, digital advertising and the relatively untapped potential from its growing ecosystem of smart devices and Prime membership and yes, even driverless technology — and for its market cap to continue trending higher over time. Based on our sales growth and margin assumptions, the numbers suggest that current valuations are not excessive despite its higher-than-market average PE multiples.
Thus, as evident simply from reading the above, stock valuation is not just an art form, but also very divisive, almost impossible to determine right from wrong sometimes and, yes, fun.
We have written many such pieces on valuation methodology and assumptions lately because where we are at the market cycle, views are increasingly strongly divided and we feel that, as investors, you ought to understand the underlying reasons for such diverging views.
The Global Portfolio closed 0.6% higher for the week ended April 28, more or less in line with the MSCI World Net Return index’s 0.7% gain. Last week’s gains bring the total portfolio returns to 61.6% since inception. This portfolio is still outperforming the benchmark index, which is up 49% over the same period.
The top gainers for the week were Alibaba Group Holding (+4.4%), Alphabet (+3.5%), and Singapore Airlines (+3.4%), while the biggest losers were Geely Automobile Holdings (-8.2%), Johnson & Johnson (-2.8%) and Microsoft (-2.3%).
Disclaimer: This is a personal portfolio for information purposes only and does not constitute a recommendation or solicitation or expression of views to influence readers to buy/sell stocks, including the particular stocks mentioned herein. It does not take into account an individual investor’s particular financial situation, investment objectives, investment horizon, risk profile and/or risk preference. Our shareholders, directors and employees may have positions in or may be materially interested in any of the stocks. We may also have or have had dealings with or may provide or have provided content services to the companies mentioned in the reports.
