Valuation Still Matters (and Always Will)


Last week, Rocco Pendola of The Street made an interesting argument that -- at least for some high-flying momentum stocks -- valuation doesn't matter. Instead, he argues that stocks like Netflix and can continue racing higher indefinitely.

According to Pendola, as long as investors remain "confident" in management, the stocks will outperform. However, valuation still matters, and it always will, no matter how irrelevant it might seem in the span of a year or even a few years.

It's true that Netflix and Amazon crushed the market in 2013, and this has something to do with investors' confidence in both companies' leaders. That said, it's not just general "confidence" that drives these stocks higher; it is investors' confidence that management will deliver a certain level of long-term earnings.

If it becomes clear that the companies have a much lower earnings ceiling, the stocks will crash regardless of how good a job management is doing. Valuation analysis is all about determining whether a company's market value lines up with its long-term earnings potential.

What is "valuation" anyway?
Some investors interpret valuation in a very narrow way through metrics like the price/earnings ratio. A typical company might trade for 15 to 20 times earnings, and some investors presume that stocks trading well above this range are "overvalued" and stocks trading below this range are "undervalued."

In this narrow sense, Pendola is right that valuation does not matter. A P/E ratio only takes into account a company's current earnings and ignores the potential for long-term earnings growth. If a business is likely to deliver exponential earnings growth for many years, a very high P/E ratio may be quite reasonable.

Netflix and Amazon both sport very high P/E ratios: Netflix trades for nearly 200 times 2013 earnings and 90 times 2014 estimates; Amazon trades for more than 500 times 2013 earnings and almost 150 times 2014 estimates. However, these stratospheric P/E ratios alone do not make Netflix and Amazon overvalued.

What really matters is how each company's long-term earnings potential stacks up against its market capitalization. Right now, Netflix and Amazon are both growing quickly, and so there is a good deal of uncertainty about where earnings will end up in five or 10 years. Nevertheless, both stocks look overvalued today; I am highly skeptical that earnings growth will live up to bulls' expectations.

Netflix: Earnings potential overblown?
Some Netflix bulls think that the company has the potential for dramatic earnings growth over the next five years. Portfolio managers David Schechter and Brett Icahn think that Netflix could grow domestic contribution profit by $3.3 billion from 2013 to 2018. All else equal, that would raise Netflix's EPS from around $2 this year to around $35 in 2018!

Explosive growth of that sort would justify an even higher valuation than the one Netflix carries today. However, as I have written previously, this scenario almost certainly overestimates Netflix's growth potential, while assuming that content cost growth will slow dramatically.

Netflix could easily triple or quadruple its earnings in the next few years, but achieving growth beyond that will be a long, hard slog. By 2015 or so, Netflix is likely to show clear signs of having saturated the domestic market.

When this happens, investors will likely abandon Netflix stock. Even if EPS seems likely to hit $8 in 2016 and Netflix retains a modest growth premium -- e.g., trading for 30 times forward earnings -- Netflix stock would have a long way to fall. To the casual observer, it may look like investors "lost confidence" in Reed Hastings, but the real driver of multiple contraction will be the reevaluation of Netflix's growth potential.

Amazon: Bigger than Wal-Mart?
Investors are probably also overestimating Amazon's long-term market opportunity. Amazon's earnings have been artificially depressed in recent years due to the company's heavy investment in a variety of areas. While earnings should rebound in the next five years, bulls are overestimating just how profitable Amazon will be.

Amazon's situation is particularly interesting because the company's market cap is around $180 billion. This makes it one of the most valuable companies in the world, despite having fairly low earnings. Clearly, investors think that Amazon will dominate the next era of retail.

However, it's worth noting that Wal-Mart is already a dominant force in global retail today, with annual revenue approaching $500 billion (more than six times higher than that of Amazon). Yet its market cap is only slightly higher than Amazon's, at around $250 billion.

Considering that it will take well more than a decade for Amazon to reach Wal-Mart's current scale, Amazon's valuation only makes sense if it will ultimately become much bigger than Wal-Mart. While that's certainly possible, it's hardly guaranteed. E-commerce does not work well in every category where Wal-Mart competes. Furthermore, Amazon's revenue growth has already slowed significantly in the last two years, calling into question its "infinite" growth potential.

Foolish conclusion
By now, it should be very clear that I think Netflix and Amazon are both overvalued. But their being overvalued has nothing to do with high earnings multiples. What makes the two companies overvalued is that their long-term earnings prospects do not match up with their recent market values.

Ultimately, slowing revenue growth will be the trigger of each stock's downfall. Investors have rewarded both companies with very high earnings multiples not because of vague "confidence in management," but because of their confidence that management will deliver strong revenue growth -- and ultimately earnings growth -- for years to come.

However, if I am right that growth prospects have become exaggerated for both Netflix and Amazon, then it is inevitable that the companies will fall short of investors' expectations, no matter how good a job management does in the coming years. When investors recognize these lower growth prospects, the stocks should fall back to more reasonable levels.

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Fool contributor Adam Levine-Weinberg is short shares of Netflix and, and long Dec. 2013 $275 puts on Netflix. The Motley Fool recommends and owns shares of and Netflix. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.

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