No-one is perfect and even the most experienced of investors make mistakes, and one mistake that I see time and time again is buying into hype and forward valuations.
I’m not going to name names – but I have seen countless articles and countless analysts deem stocks ‘obvious’ and ‘stunning’ buys based purely on projection.
Only today I saw an analyst call Cineworld Group plc a stock that “fully merits a slightly-elevated forward P/E rating of 18.1 times”.
But how do we know that in one year Cineworld will indeed achieve its forecast earnings? Maybe it’ll be higher, maybe it’ll be lower, who knows? But we must remember that tens of analysts that evaluate stocks. Some place Cineworld’s estimated EPS for 2016 at 34.2p a share giving you a forward p/e of 17.5. Some place Cineworld’s estimated EPS for 2016 at 30.68 giving you a forward p/e of 19.5. Who knows which analyst is correct?
One thing we do know and that is that the stock currently trades at a s p/e of 19.62. Definitely overvalued for a cinema chain!
But Analysts are professionals, surely they get things right?
You would think so but this couldn’t be further from the truth. Analysts use a range of different methods and take a range of different views on stocks in order to estimate anything from price targets to earnings. If analysts really had the market figured out, why do their valuations vary and why did many close due to wrong predictions during the 2008 market crash?
If we take an extreme example of how wrong analysts, predictions and hype can be we don’t need to travel further back than 1999 and the dotcom bubble for some perfect examples.
During this period the US stock market’s p/e rose to 32 and many tech stocks with negative EPS were trading at p/e of over 100 simply because they sounded cool. We’re only now seeing tech companies like Microsoft and Verizon return to their 1999 levels – 17 years later, after trading hands at ridiculous valuations at the bubble’s peak.
In 1999, Wall street was buying with both hands and analysts predicted never-ending EPS growth of 100’s% yearly until the bubble burst in early 2000. But, those looking at the facts during this period could see that such valuations were ludicrous and the EPS projections farcical and were spared the losses that bankrupted many investors.
How about an example of these valuations?
Let’s take Yahoo – on January 3rd 2000, Yahoo shares closed at an all time high of $118.75 per share, doubling in price since December 1999. Their earnings per share for that year came out at $0.05 putting the company’s valuation at 162x earnings. On September 26 2001 their shares were worth just $8.11.
Current examples of irrationality
I often get criticized by friends and colleges for not buying in to ‘stocks of the future’ a few names that instantly come to mind are – Amazon, Netflix and Tesla.
Well let’s look at the facts,
Amazon trades at a p/e of 192 (ttm). It’s EPS were negative for 2012 and 2014. Even if I took the highest analyst estimates for EPS in 2017 of $15.55, purchasing the stock today for $770 would give me a p/e of 50. There’s absolutely no value in the stock at this level.
Tesla hasn’t recorded a year of positive EPS figures yet, has a net loss of $886m worldwide yet astoundingly trades at a valuation of $226 per share!
Netflix on the other hand has a p/e ratio of near 300 (ttm). But I’m sure it’ll all be ok because the company is expected to earn 0.89c a share in 2017 up from the 0.25c per share the company recorded in 2015. Even if we took the highest estimate for EPS in 2017 which is $1.38 this would give us a p/e of 69 in 1.5 years time.
Conversely, I could buy Walmart today, for 16.33 times earnings and receive a 2.71% yield and annual dividend increases for the foreseeable future. There’s no mystic ball needed here. These are facts.
When you’re buying a stock, you’re buying a part of a company. You can sell your part of that company to Mr Market whenever you like – for the price he offers. But, one thing you should learn is that Mr Market is sometimes (often) irrational and can offer you ridiculous valuations for your part of a company be it to little or too large a valuation.
For example, If you went to a car dealership and bought a car you knew was worth £1,000 for £1,000 and parked it outside your drive, you would be content in knowing you have a £1,000 asset sitting outside your house. So, what would you do if Mr Market knocked on your door and offered you £500? You wouldn’t sell it of course, knowing full well your car is worth £1,000.
But, what if when you went to the car dealership and the salesperson said to you;
“I know this car is only worth £1,000 today, BUT our dealership, and other dealerships estimate that this car will be worth £5,000 in three years. I tell you what, I’ll give it to you today for just £2,500.”
If you bought that car and parked it outside your drive, how do you know that Mr Market will knock on your door in three years and pay you £5,000 for it? How do you know that that car will indeed appreciate in value at all?
The mistake would be to buy the car for £2,500. The mistake investors often make is to buy a stock for well over the market/sector’s average p/e in the hope that the analysts were correct when they projected forward earnings.
I must admit that I have indeed done this and it didn’t end well. I’ll be writing an article on my mistake this Monday. Have you ever made this investing mistake? Comment below.
Disclosure: I have no positions in any of the stocks mentioned and no intention on initiating a position within the next 72hours.
All figures taken from ft.com