2.27.14: February ’14 and the concept of valuation

Before trading has opened today on February 27th, the SP 500 is slated to be up sharply from the 1,782 close on Jan 31, today’s pre-market trade of 1,838. That leaves us with a 3% gain in February and a slight decline for the two-months, year-to-date.

With Tesla (TSLA) the stock of the moment, and talking about the stock with clients, it reminds me of the how hard it is to explain the concept of “valuation” of a particular stock, and how that can get distorted by the CNBC or Bloomberg commentators or guests depending on their bias (long vs. short), or their market view.

With valuation, you can have a stock look cheap on “absolute” valuation metrics like Hewlett-Packard (HPQ) and Best Buy (BBY) which were trading at 2(x) cash-flow in December ’12, and looked to be screaming buys (we are long HPQ), and you can have stocks look cheap on “relative” valuation metrics as the large-cap growth stocks were valued in the late 1990’s. Technology companies were compared to other technology companies, e.g. software stocks and you have had p.e’s compared and growth rates compared, and the 5th most expensive stock out of the group of 5 was then “considered” cheap (or cheaper) or a relative valuation basis, by a sell-side analyst and it was then recommended to clients.

While sitting at my favorite Greek diner in Old Town in Lincoln Park, Chicago, in the late 1990’s I used to hear people chatting about the market, and I would hear comments like, “It is a $100 stock, it is too expensive” or “Im going to wait until it trades under $2, you could have bought Microsoft under $2 a share” (with the speaker not realizing that MSFT never traded at $2 per share, but when the shares were “split-adjusted” an early investor might have a $2 cost basis. (Long MSFT.)

In other words, many retail investors seem to think a $100 price is “expensive” while a $5 share price is “cheap”, not realizing that a $5 stock could be wildly overvalued relative to $100 stock. (Think JCP vs XOM. On just about any valuation metric XOM is far cheaper than JCP, because JCP is expected to lose money through 2017. However that can change too. Long XOM).

Another good example is Amazon (AMZN): many pundits frequently quote AMZN’s 1,400 (x) p.e ratio as being “wildly overvalued”. However if you look at AMZN’s price-to-cash-flow ratio, it is trading at just 30(x), cash-flow, which isn’t a screaming buy, but it makes the stock look far cheaper than a 1,400(x) p.e, and the 30(x) price to cash-flow ration leaves AMZN trading about as expensive as Nike, and far cheaper than UnderArmour (UA). Two other high-quality retail brands.

Tesla today is a very expensive stock: according to Thomson Reuters consensus analyst estimates (and prior to the last earnings report since I haven’t updated our spreadsheets), TSLA was trading at 150(x) the expected then 2014 consensus of $1.58 and 84(x) the 2015 consensus for expected growth of 250% and 100%. Per one source, TSLA’s earnings growth is expected to average (!) 50% per year for the next 5 years, which in comparison, makes the valuation of TSLA seem reasonable.

The point of this blog post being that “valuation” is a tough concept to get your arms around, and it can mean very different things to very different people.

We are long Tesla as well as Alcoa(AA) and US Steel (X), which are stocks at completely opposite ends of the valuation spectrum, and I tell clients, the TSLA’s, Twitter’s (TWTR) and Facebook’s (FB) all have to be traded, while the Hewlett-Packard’s (HPQ and 5(x) cash-flow), the Alcoa’s and the US Steel’s we can sit on and be patient with. (Long all of the above stocks mentioned. Alcoa JUST traded above its tangible book value per share price of $11. I still think the stock is cheap on an “earnings power” basis.)

Our style is to blend value stocks with growth stocks or value sectors with growth sectors. Trade the growth areas, be patient with the value names.

And always, always, when you hear the word valuation, understand that that word’s meaning can vary widely depending on who is using it, and how it is being used.

Trinity Asset Management, Inc. by:

Brian Gilmartin, CFA

Portfolio manager







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