How Unrealistic Are Tech Stock Prices?

Technology super hero

During the 1960–70s, it was all too easy to make money.

US investors simply bought and held blue chip growth stocks.

The thought was, because of their size, stability and prospects, these blue chip growth stocks would continue to climb higher forever.

No need to reach annual reports. No more analysis of business models. Investors thought if they bought any one of the 50 blue chips stocks, they were destined for riches.

It sounds ridiculous today. But I’m sure many of us might have done the same.

We now know this era of investing as the Nifty Fifty. Companies like IBM, Gillette and Polaroid traded for ridiculous prices. And as long as prices kept creeping up, investors were all too happy to continue buying.

But as always, it all soon came crashing down in 1982. Investors continue to mention the Nifty Fifty in an attempt to quell unrealistic growth expectations.

Will we see a similar situation play out for tech stocks globally?

 

Unrealistic expectations

As tech stocks continue to climb, the word bubble has gained new life. Take a look at what Bloomberg wrote yesterday:

Bubble warnings are getting louder. American tech giants keep surging ahead of the market, with the Nasdaq Composite Index closing a fresh record.

…tech stocks are worth a lot. At $US3.8 trillion, the combined value of Facebook, Amazon, Apple, Microsoft and Google’s parent Alphabet tops the annual gross domestic product of Germany, and all the companies in Japan’s Topix index of stocks.

The same thing has happened in China. Tech conglomerates like Tencent Holdings Ltd [HKG:0700], Alibaba Group Holdings Ltd [NSYE:BABA] and Baidu, Inc. [NASDAQ:BIDU] continue their climb upwards.

 

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Source: Yahoo Finance
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Then there’s stocks like Netflix, Inc. [NASDAQ:NFLX] and WiseTech Global Ltd [ASX:WTC] that trade on enormous price-to-earnings (PE) ratios.

Netflix has a PE of 280 and WiseTech has a PE of 150.

That means investors are paying $280 and $150 for every dollar of 2017 earnings. But who the hell would pay that much for a measly dollar of earnings?

Well, it’s because investors in both stocks believe earnings will grow over time. And they’re probably right. But how fast can earnings realistically grow from here?

 

 

Let’s reverse engineer the question.

Let’s take a look at how much Netflix and WiseTech would need to grow earnings to achieve a long-term PE of say 35.

To achieve this in five years, both companies will have to see extraordinary earnings growth within the next couple of years. And of course both stocks won’t stand still in the meantime.

Let’s assume both Netflix and WiseTech stock grows at about 20% a year.

Using the assumptions above, Netflix would need to grow earnings by 79% and WiseTech by 58% every year for the next five years.

 

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It’s doable. But is it realistic?

Maybe not.

Yet, that doesn’t make every tech stock trading on a sky high PE is overvalued. In fact, had you bought some stock, even at high multiples, you would have done extremely well over time.

To demonstrate my point, let’s take a look at REA Group Ltd [ASX:REA].

 

Look at value not price

REA Group is the owner of realestate.com.au. It is the site to look for Aussie property. This strong network allows them to increase earnings without much trouble at all.

Had you been looking at the stock in 2005, it was trading for 19-times earnings. The next year, the stock shot up to trade on a PE of 52.

Too expensive now, you might have thought. Well, had you passed up on buying REA Group on a PE of 52 in 2006, you would have missed out on a more than a 1,500% gain.

The same goes for Chinese tech firm Tencent.

From 2004–07, Tencent went from trading on a PE of 17 to 62.

Clearly another stock that’s raced above what it’s worth? Yet had you passed on Tencent in 2007, you would have missed out on a 3,500% gain.

Or what about Amazon.com, Inc. [NASDAQ:AMZN]?

From 2008–12, the Everything Store went from trading on a PE of 36 to 662. Who the hell is going to pay $662 for each dollar of future earnings?

Yet had you also passed on Amazon, you wouldn’t be able to tell people you’ve close to doubled your money each for the last five and a half years.

It’s pretty clear, to me at least, that PE ratios wouldn’t do you a world of good when deciding which stocks to buy.

Much better is to try and estimate a company’s value. If they can continue to grow earnings by X%, what might they be worth today?

Like I mentioned in yesterday’s Money Morning, forget about price and first try and determine the value (or potential future value) of the stocks you own.

Then the next decision will be obvious. If you think something is worth X, it’s either overvalued, undervalued or about right.

 

Your friend,

Harje Ronngard,
Editor, Money Morning

Harje Ronngard

Harje Ronngard

Harje Ronngard is the lead Editor at Money Morning. With an academic background in finance and investments, Harje knows how simple, yet difficult investing can be. He has worked with a range of assets classes, from futures to equities. But he’s found his niche in equity valuation.

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