When Market Cap Trumps P/E
Last week, I wrote an article on when to ignore a company's price-to-earnings ratio (P/E). In a nutshell, the popular metric can become misleading when a company is just becoming profitable, or can be justified by incredible growth rates.
While readers appreciated the article, they were left wondering what metrics should be used when P/E doesn't matter. Earlier this week, I showed how growth rates could be of use in valuing highfliers. Earlier today, I demonstrated how zeroing in on free cash flow instead of earnings could be of use in certain industries.
Today I'm focusing on situations where looking at a company's market capitalization -- relative to market opportunity and competition -- can be far more useful than its P/E. At the end, I'll offer you access to a special free report that highlights three companies changing the face of manufacturing in America.
Often times, beginning investors become fixated with a company's stock price as the main value indicator for the security. But in reality, nothing could be further from the truth.
If a company is valued at $100, it makes no difference if there are 10 shares at $10 apiece, or 20 shares at $5 apiece. The end result -- the market capitalization, or market cap -- is the same: The company is worth $100.
Sometimes, when we focus so intently on a company's P/E ratio, we forget the larger market that a company is growing into.
Look at competition
One of my favorite thought exercises for this is to look at industry stalwarts and their market cap as an indication of growth possibilities for up-and-comers. For instance, Wal-Mart (NYS: WMT) is the undisputed leader in worldwide retailing. The company currently has a market cap of $203 billion.
But will Wal-Mart always be a retailing leader? I would argue that if any competitor were to dethrone the company, it would Amazon.com (NAS: AMZN) . Sure, many investors are scared away by the company's P/E of 187. But as I've shown, that number is partially inflated by the fact that the company is building out its array of fulfillment centers to guarantee no one else will be able to touch it when it comes to customer service and quick delivery.
Just as important, Amazon currently has a market cap of $102 billion, or about half of Wal-Mart. Of course, there's no guarantee that Amazon will fulfill its potential as the dominant e-tailer of the future -- but with its huge moat, smart backing, and a record for excellent customer service, I don't think a sky-high P/E should automatically eliminate it from your watchlist.
Tomorrow, Facebook will be having 2012's largest IPO. While some argue it will be wildly overvalued and others see the chance for future growth, one thing is a pretty safe bet: The company will have a market cap over $100 billion.
Last year, Facebook grew revenue by 88% and net income by 65%. That's impressive. But consider that advertising is the main source of income for the company, and that it already has 900 million users, and you might be left wondering where growth will come from.
Juxtapose those stats against what LinkedIn (NYS: LNKD) has going for it. The company has only 161 million registered users and derives just 30% of its revenues from outside the Americas. Clearly, there's a still lot of room for growth.
And with three streams of revenue that have absolutely nothing to do with click advertisements, those streams appear far more reliable than Facebook's. Just last quarter, LinkedIn's revenue grew by 101%, while net income jumped 140%.
Yet because LinkedIn has a P/E of 774 -- which is largely a result of having just became profitable -- many investors are steering clear. But the company's market cap is only about one-ninth the size of Facebook. Looking at it from this point of view, you could make a reasonable argument for buying into LinkedIn -- which I've already done.
Look, neither LinkedIn nor Amazon is necessarily a screaming buy right now, but they also aren't as wildly overvalued as some may have you believe -- once you compare their relative size (market cap) to their future potential.
My favorite market-cap companies
In the investing world, there are two companies that get me very excited when it comes to future possibilities. Stratasys (NAS: SSYS) and 3-D Systems (NYS: DDD) are the leaders of a revolutionary new industry: 3-D printing.
Though the companies look expensive today, with P/Es of 54 and 41, respectively, they are still small -- both sport market caps of less than $1.5 billion. If either company fulfills just half of its potential as America's manufacturing leader in the coming decades, investors are sitting on wealth-producing multibaggers.
To find out what I mean about 3-D printing and its ability to revolutionize manufacturing in America, I suggest you check out our special free report: "The Future Is Made in America." Inside, you'll see why today's market caps of less than $1.5 billion could seem tiny in coming years. Get your copy of the report today, absolutely free!
At the time this article was published Fool contributorBrian Stoffelowns shares of Amazon, LinkedIn and Stratasys. You can follow him on Twitter, where he goes byTMFStoffel. The Motley Fool owns shares of LinkedIn and Amazon.com, and has written calls on 3-D Systems.Motley Fool newsletter serviceshave recommended buying shares of 3-D Systems, Amazon.com, Stratasys, and LinkedIn, as well as creating a diagonal call position in Wal-Mart. The Motley Fool has adisclosure policy. We Fools don't all hold the same opinions, but we all believe thatconsidering a diverse range of insightsmakes us better investors. Try any of our Foolish newsletter servicesfree for 30 days.
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