If You’re Investing Based on the Valuation of a Company, You May Be Resting Your Money in a Bed of Speculation.
The valuation of a company or stock, is how much a company is thought to be worth, based on a variety of factors.
We in the financial media devote a lot of ink to breaking down whether a stock is undervalued or overvalued based on its price-to-earnings ratio, price-to-sales ratio, PEG ratio, etc. Through that lens, you can identify which stocks are ready to explode and which are due for a pullback.
That said, certain stocks defy the laws of market physics, and continue to rise for years with impunity.
For example, let’s look at Snapchat, Snap Inc. (SNAP). Their valuation exceeded the likes of Target (TGT), CBS Corp. (CBS), Chipotle (CMG), Hershey (HSY), Yum! Brands (YUM) and Wynn Resorts (WYNN). Unlike those companies, Snapchat has never made a penny from its popular photo- and video-sharing application. But Snapchat excites people, millennials in particular, and Wall Street taps into that potential, drinking the Kool-Aid of the company’s promises of what’s to come.
Perhaps they’re right. Maybe they’ll make so much money in ads and partnerships, that it’ll all pay off. Or maybe they’ll be bought. Then again, for all the exceptions to the rules of stock valuation over the years, market history is littered with probably 10 times as many (or more) stocks that have succumbed to it. Look no further than Snapchat’s social media counterpart, Twitter (TWTR).
Twitter exploded out of the gates too, coming public at 41 in November 2013 and kiting to 69 in less than two months. Then, reality set in: investor excitement waned, the company reported another quarter of significant losses, and TWTR stock plummeted to 30 by May 2014 and has stayed in that range since, with ups and downs.
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Hidden Values in the Valuation of a Company
The reason why there’s so much disparity in a stock’s earnings versus their valuation is because there may also be additional factors considered. When you become a value investor, you become attuned to hidden values.
Value refers to potential capital gain opportunity in the stock market. Strong balance sheets, good earnings growth, and low price-to-earnings ratios (P/Es). Other hidden values that go into a valuation could be real estate owned by the company, patents on intellectual property, or secondary revenue streams that could become bigger sectors of business in the future. Partnerships a company has with other companies can also come into play when coming up with a valuation of a company.
So as you can see, valuations are based on a number of factors and influences, but it’s still up to the individual investor to decide if they believe the hype, or to the contrary, if they see an underdog who is going to spike. That’s where value investors see the payoff, in identifying undervalued stocks and acting on them.
The father of value investing, Benjamin Graham, has a fun parable that is good to take into account when thinking about valuations. In his book The Intelligent Investor, he writes:
“Imagine that in some private business you own a small share that cost you $1,000. One of your partners, named Mr. Market, is very obliging indeed. Every day he tells you what he thinks your interest is worth and furthermore offers either to buy you out or to sell you an additional interest on that basis. Sometimes his idea of value appears plausible and justified by business developments and prospects as you know them. Often, on the other hand, Mr. Market lets his enthusiasm or his fears run away with him, and the value he proposes seems to you a little short of silly.
“If you are a prudent investor or a sensible businessman, will you let Mr. Market’s daily communication determine your view of the value of a $1,000 interest in the enterprise? Only in case you agree with him, or in case you want to trade with him. You may be happy to sell out to him when he quotes you a ridiculously high price, and equally happy to buy from him when his price is low. But the rest of the time you will be wiser to form your own ideas of the value of your holdings, based on full reports from the company about its operations and financial position.
Graham’s point is that the investor should not regard the whims of Mr. Market as determining the value of the shares that the investor owns. He should profit from market folly rather than participate in it. Instead of investing solely on a valuation, the investor is best off concentrating on the real-life performance of his companies and their dividends, rather than being too concerned with Mr. Market’s often irrational behavior.
Do you have any stories of how the valuation of a company led you to invest, that could benefit our other readers? Leave a comment below.