In America, the land where Silicon Valley tech giants dominate, the financial services industry’s tried and true valuation metrics have been put to the test.
Facebook, Amazon, Apple, Netflix and Google, known collectively as the ‘Faang’ stocks, now make up roughly 15% of the S&P 500 by market cap. They have accounted for 48% of the Nasdaq Composite Index’s gains this year, according to Bloomberg data.
In early August, Apple made history by becoming the first $1trn company as its shares touched $207.05. A month later, e-commerce giant Amazon has joined the iPhone maker in the trillion-dollar market cap club.
Though many analysts predicted they would run out of steam, the share prices of the Faangs have continued to surprise, surviving scandals that could have easily toppled other businesses, and rebounding swiftly from quarterly earnings let-downs.
Tech titans beyond value
Their spiritedness has convinced some that value investing is dead and that the worth of these tech titans cannot be distilled down to a number. “We do not think a static single data point can ever adequately capture the value of a company like Amazon,” says Catharine Flood, client director at Baillie Gifford.
Baillie Gifford is among Amazon’s largest institutional shareholders, owning some 5.8 million shares in the firm. The e-commerce giant is the biggest holding in the Edinburgh manager’s Scottish Mortgage Trust, making up more than 10% of the fund.
Baillie Gifford has cultivated a reputation for being an unapologetic long-term growth investor. The firm’s strategy revolves around seeking out and investing in what it calls “extraordinary growth companies” on the basis that, historically, only a handful of businesses dominate long-run equity market returns.
Flood says of Amazon that it is the “epitome” of such an investment.
For all the Faang and high-growth tech optimists, plenty of bears abound. A recent Bloomberg report revealed that bearish investors have shorted $37bn worth of Faang stocks, up by 40% in the past year. Elon Musk’s electric car company Tesla, in which Baillie Gifford also has a majority stake, is the largest short in the US stockmarket, with $10.7bn of the company’s shares out on loan to hedge funds, according to S3 Partners.
George Godber, co-manager on the Polar Capital UK Value Opportunities Fund, says bold proclamations that the Faangs are beyond traditional value metrics is a sign of a boom that is about to go bust. “The Faangs are amazing businesses,” says Godber, “but they are no different to any other company. Are they any more revolutionary than railway stocks were in the 1800s? Probably not.”
Adrian Lowcock, head of personal investing at Willis Owen, does not believe Faang stocks are beyond traditional valuation metrics. He says the same sorts of anti-valuation arguments were used to rationalise the high premiums of the ‘nifty 50’ stocks of the 1970s, tech firms during the dotcom bubble and oil & mining companies amid the commodities supercycle.
“Wall Street, and everyone else for that matter, gets caught up in the story and the idea,” says Lowcock. “It’s usually then that people say traditional valuation methods don’t apply here. Well, they do, it’s just that ultimately you’ve got to make a profit and return that to your shareholders at some point.”
Competitive advantage versus P/E
The ratio of share price to annual earnings, known as P/E, remains the industry standard for valuations.
The P/E ratio of a growth company like Amazon, currently trading on 159.86x, looks skewed because it re-invests most of its earnings to fund future expansion. Earlier this year, the e-commerce giant was on 260x, while in 2012 it had a P/E ratio of around 3,000x.
According to Flood, the P/E metric runs counter to one of the most crucial elements in the investment case for Amazon. “Jeff Bezos relentlessly re-invests Amazon’s cashflows in its future growth, at the expense of near-term earnings, but to the benefit of its long-term competitive position and growth. Such investment is precisely why the company is the Amazon we know today,” she says.
“Valuations for growth stocks are almost entirely based on their ability to generate stronger sales, margins and therefore cashflows well into the future,” admits Jake Robbins, senior investment manager of the Premier Global Alpha Growth Fund. “This makes more traditional metrics such as P/E or price to book (P/B) less relevant as investors are buying the promise of growth rather than anything based on more near-term metrics.”
Robbins adds that the cyclically adjusted P/E or Cape, another popular metric in the US, has also been a poor indicator of value for the Faangs because of its inability to square their consistently strong growth. “Cape assumes that earnings revert to some mean level over time, whereas many technology names have consistently grown earnings with no sign as of yet of any mean reversion,” he says.
The more metrics the merrier
Sanjiv Tumkur, head of equity research at Rathbones Investment Management, says it is crucial to weigh up several methodologies to get the most accurate impression of a company’s value.
Rathbones typically uses two to three valuation metrics per stock, including P/E, enterprise value to Ebitda (earnings before interest tax, depreciation and amortisation), which encompasses debt and other outstanding costs, and free cashflow yield. A highly leveraged company that is trading on a low P/E will show up as being expensive on an EV/Ebitda basis, for instance. But Tumkur says both metrics can be easily manipulated through some clever accounting.
Using multiple metrics to assess stocks is important because “there is no silver bullet, no one valuation metric that works for every single sector across the market”, says Tumkur. Free cashflow yield is not especially helpful when valuing financials because they have cash coming in all the time because of their day-to-day operations.
Robbins prefers discounted cashflows for assessing high-growth stocks such as the Faangs as “this tends to allow for the majority of the value of a business lying far into the future”. “It is also extremely sensitive to growth expectations and explains why, when sentiment turns more negative on growth stocks, their stocks can be highly volatile,” he says.
Tumkur believes some of the Faang stocks do not look like they are trading on demanding valuations. He says Google parent company Alphabet and Mark Zuckerberg’s $507bn social network empire Facebook look reasonable on a forward P/E ratio, which uses predicted instead of actual earnings, of 25x and 26x, respectively, considering their growth potential. He thinks they look fairly valued on a free cashflow and Ebitda basis also.
“You can look at the conventional valuations and say, actually, that’s fair given these are high-growth businesses. They have got user bases in the billions around the world, huge advantages in terms of R&D spending and the ability to make money from things like artificial intelligence.”
Lowcock says the same can be said of Apple, which is trading on a “surprisingly reasonable” P/E of 17x to 18x earnings.
However, companies like Amazon and Netflix, which “are absolutely burning cash” need to be looked at differently, says Tumkur.
Tesla, though not technically a Faang stock, has also proven exceedingly difficult to value accurately. Shares in the company have risen by 2,000% since the company went public in 2010, but it does not have a reported P/E because its earnings remain in negative territory.
Tesla tests valuations
Baillie Gifford, which owns 7.72% (13.2 million shares) of Tesla, has been on the receiving end of harsh criticism for its continued conviction in the electric car company and its refusal to speak out on the recent antics of the firm’s billionaire founder, who announced out of the blue via Twitter his intention to take the company private. Lowcock says he has been put off investing in Scottish Mortgage Trust because of its hefty Tesla position.
Baillie Gifford’s £8.1bn closed-ended vehicle holds 1.04% or 1.8 million shares of its total stake. The electric car company is the fifth-largest holding in the portfolio. “I really rate them,” Lowcock says of the Scottish Mortgage team, “but I’ve never been able to buy the trust because I just cannot understand the Tesla holding.”
Tesla is “a beautiful story”, he adds, but doesn’t have “first movers’ advantage”. “I can understand the argument for Amazon; the valuation may be a bit high but the growth potential is colossal. I can even understand the argument for Netflix; it isn’t profitable but it is a growth business and a disruptor.”
By contrast, Lowcock says the car manufacturing industry has always been risky, “laden with huge amounts of debt” and has gone through Chapter 11 bankruptcy in America “god knows how many times”.
Tumkur agrees that Tesla is not operating in a vacuum and is facing pressure from auto majors like Volkswagen and Ford that have begun investing heavily in electric cars. He regards Tesla as “a higher risk investment”.
Scottish Mortgage Trust manager James Anderson says the team are “committed owners of Tesla because we think there is a very favourable, probability adjusted, potential payoff in consistently backing the company and its management”.
Anderson argues the potential asymmetric payoff is worth the risk.
“The upside from here, if Tesla succeeds, is much larger than the capital we have invested – just as it has been since we started owning the stock when it was $30-40.”
Robbins disagrees, regarding Tesla as “highly speculative” at this stage.
“Once technology becomes more established, those companies best positioned to benefit from this growth become more apparent,” he says. “At this point, many less familiar names involved in the supply chain to enable autonomous vehicles or artificial intelligence can offer extremely attractive valuations, given their long-term secular growth trends.”
