Today, I want to compare the values of Amazon.com (AMZN) and Facebook (FB), two of the market’s great growth stocks in recent years. Could you make the case that either AMZN stock or FB stock is actually still undervalued? More on that in a bit. First, let’s examine what’s going on in the market…
Stock Market at a Glance
Volatility returned to the stock market last week. Investors are concerned about the possibility of a Fed interest rate hike this week after a batch of weak economic news indicated that the U.S. economy will continue to sputter. Additional worries that central banks in Europe and Japan have run out of ways to spur economic growth abroad didn’t help. And the election for a new U.S. President has become a dead heat, adding more uncertainty for investors.
In my opinion, the stock market will remain volatile for another month. However, you can take advantage of buying opportunities when the stock market dips noticeably. My advice is to be cautious and buy well-established undervalued stocks during market weakness.
Rapid Growth at a Reasonable Price
I usually search for quality stocks growing at modest growth rates and selling at very reasonable prices. But today, I will focus instead on rapidly growing companies with which every investor is familiar.
To prepare for today’s column, I took a close look at 12 companies: Alphabet (Google), Amazon, Apple, Applied Materials, Edwards Lifesciences, Facebook, Intuitive Surgical, Mohawk Industries, Netflix, NVIDIA, Priceline and Ulta Salon.
I quickly concluded that Amazon (AMZN) and Facebook (FB) were the best of the bunch. The two companies are growing at a very fast pace, both dominate their current markets, and will continue to innovate and create new products and services. Both companies share another important asset: great leaders.
Is either of these companies undervalued?
AMZN stock sells merchandise and products purchased for resale from vendors as well as from third-party sellers through retail websites such as amazon.com. 1-Click shopping, Kindle Direct Publishing, Kindle, Fire tablets, Fire TV, Amazon Echo and Alexa are some of the products and services pioneered by Amazon. Amazon is led by Jeff Bezos, the 52-year-old founder, chairman and CEO.
Amazon earned $4.02 per share and generated $121 billion in sales during the 12 months ended June 30, 2016. The company is expected to grow earnings at a torrid 50% rate during the next three to five years with more rapid growth expected during the next two years. However, at 193.6 times current EPS (earnings per share), AMZN shares appear to be clearly overvalued. However, we can examine AMZN further by calculating the stock’s PEG ratio.
Using the PEG ratio to determine if a stock is undervalued or overvalued provides a clear evaluation for a growth stock. The PEG ratio is calculated by dividing the price-to-earnings ratio by the expected earnings per share growth rate during the next five years. Based on the company’s current EPS and expected earnings growth (50% per year) during the next five years, AMZNs current PEG ratio is 3.87. However, if we look at Amazon’s future value two years from now, AMZN’s PEG ratio is a more reasonable 1.98.
I like to buy growth stocks with PEG ratios of 1.00 or below. To achieve a two-year forward PEG ratio of 1.00, AMZN shares will need to plunge to 393.50. I doubt that AMZN will drop to 393.50 anytime in the future. Therefore, I recommend avoiding Amazon unless you are a nimble trader and can time your purchase and sale profitably.
FB stock enables people to connect, share, discover, and communicate with each other on mobile devices, personal computers and other electronic gadgets worldwide. Facebook is led by Mark Zuckerberg, the 32-year-old founder, chairman and CEO.
FB stock earned $2.12 per share and produced $22 billion in sales generated by 1.1 billion daily active users as of June 30, 2016. The company is expected to grow earnings at a 35% pace during the next three to five years with more rapid growth expected during the next couple of years. At 60.6 times current EPS (earnings per share), Facebook shares appear to be overvalued.
But using the PEG ratio to determine if Facebook is undervalued or overvalued provides a clearer evaluation for FB stock. Based on the company’s current EPS and expected earnings growth during the next five years, Facebook’s current PEG ratio is 1.74. However, if we look at Facebook’s future value two years from now, we find that Facebook’s PEG ratio is 1.09.
As I mentioned, I like to buy growth stocks with PEG ratios of 1.00 or below. To achieve a two-year forward PEG ratio of 1.00, Facebook shares need to fall to 118.50. I usually don’t use forward PEG ratios, but Facebook is a great company with a proven track record and exceptional management. I believe you will be well rewarded if you purchase FB stock at 118.50 or below.
Timothy Lutts heads one of America’s most respected independent investment advisory services. Each week, Tim personally picks the single best stock in his exclusive Cabot Stock of the Week advisory. Build your wealth and reduce your risk with the top stock each week for current market conditionsLearn More