Last week, I may have ruffled a few feathers when I argued that Google (Nasdaq: GOOG) is cheap. The stock has more than doubled since going public last summer, and most of the trailing metrics that investors traditionally use to gauge value would cause dizziness. But Google is cheap. There are actually more than a few stocks out there that may seem expensive but have what it takes to be bargain-basement buys right now.
Perhaps that's why I have a hard time understanding someone who assumes that because our Motley Fool Rule Breakers newsletter service aims to single out "ultimate growth stocks," it's just a stock-picking buffet of pricey highfliers. There are people out there who truly believe that "buy high, sell higher" is a philosophy that applies only to profiting from market bubbles before the mania subsides. They just can't grasp the concept that a quality growth stock can be dirt-cheap in retrospect, even when metrics at the time indicated that it was expensive. The trick is to determine which companies with "expensive" stocks right now have the kinds of futures that will blow away present valuations.
The mall tells all
Still not convinced? Let's hit your favorite outlet mall. Shoppers have no problem understanding that the true meaning of value goes beyond sticker price. Food that has passed its expiration date or clothes that you would never be caught dead wearing aren't a bargain at any price. Right? Of course.
If you found a pair of shoes selling for five times as much as another, but you were assured that the pricier shoes were built to last 10 times longer, wouldn't the real bargain be the more expensive pair? After all, you might even be willing to pay 10 times as much -- or more -- just to avoid the hassle of having to keep replacing the shoddier shoes.
This is a concept that every mall shopper can grasp: Good deals are based on future value. Why don't investors apply the same logic to the market? Why ignore the speedometer or the road that lies ahead in favor of the rearview mirror? It makes about as much sense as loading up on rotten produce or polyester leisure suits.
Real stories of real growth stocks
In the summer of 1998, many investors were aghast to find shares of Yahoo! (Nasdaq: YHOO) trading at 100 times trailing sales. In their minds, no reasonable person would buy into the stock at such a lofty multiple.
Yahoo! went on to soar much higher, but some still criticize it for being exorbitantly expensive. Was 100 times sales too steep a price to pay for a company growing so fast? The stock is trading three times higher today.
One of the emails that I received after my Google piece was from a reader who was upset that I used the word "cheap" to describe Google. The reader argued that with Google at "10 times sales," I was out of line, and that while Google's value may be relative to other dot-com stocks, "cheap seems wrong."
I explained that Google is actually selling at nearly double 10 times trailing sales. But I also explained that judging a company with Google's bright future based on a revenue multiple is, at best, an incomplete evaluation.
This past quarter, Google earned $369 million on $1.256 billion in revenues. That translates to a profit margin of nearly 30%. If you back out Google's traffic acquisition costs to arrive at a more industry-standard revenue base of just $794 million during the period, Google's margins puff up to 46%.
Do you realize what that means? I can throw out a list of supermarket operators that look dirt-cheap based on their price-to-sales (P/S) ratios, but for those that dare to be profitable, margins hover close to 1%. That means that for every dollar in sales that the grocers ring up, just one penny survives its way to the bottom line. For Google, every dollar that it generated in revenues beyond paying its third-party ad partners resulted in $0.46 in profit. How can anyone dare to make the mistake of judging Google solely on the top line when every single buck works so much harder than the market average?
In the past three months, analysts have moved Google's profit target for next year from $4.38 to $6.16 per share, with some going as high as $7 a stub. Paying 30 to 35 times next year's earnings for a company growing as quickly as Google is not expensive. It's a great price for shoes that were made to last.
Marrying metrics is as bad as being in-gauged
It gets even harder to evaluate growth stocks when profitability isn't there. That's when valuation pundits really start to lose it. A company such as Overstock.com (Nasdaq: OSTK) is simply assumed to be overpriced because it cannot even be evaluated by a price-to-earnings (P/E) ratio. I imagine that the same critics who deem Google overvalued on a P/S basis also gloss over the fact that Overstock is fetching just 1.2 times trailing sales.
I won't fall victim to the same kind of two-faced hypocrisy that I am rallying against. I'm not going to argue that Overstock.com is cheap because of a low sales ratio. Online retail is mostly low-margin turf. Yet this particular retailer -- a Rule Breakers recommendation, actually -- saw its sales more than double this past quarter.
When a company is growing quickly, investors shouldn't spend too much time wondering where a stock has been as much as pondering where it will be going. Some of the most lucrative investments that David Gardner made in the 1990s -- stocks that appreciated in value many times over -- certainly didn't seem like conventional bargains. In 1997, Amazon.com (Nasdaq: AMZN) was hemorrhaging money and had just $147 million in annual sales. In 1999, eBay (Nasdaq: EBAY) was barely profitable, with revenues of just $224 million.
Nobody said that these stocks were cheap at the time. They were the fancy shoes. But they were bargains that are worth considerably more today than they were back then.
That's why you won't hear me bellyaching about a stock being overvalued based only on trailing metrics. Companies such as XM Satellite Radio (Nasdaq: XMSR) and Sirius (Nasdaq: SIRI) are trading at ridiculous multiples right now -- in Sirius' case, one can argue that the gauges may be outright ludicrous. But take the time to connect the dots. Add the eventual subscriber base for digital radio, the incremental greenbacks from sponsorships that won't interfere with commercial-free music, the online streaming potential, and the secret sauce of having a dynamic captive audience, and you see the potential for hefty future revenue streams.
Cheap isn't a tangible quality; it's one that is determined retroactively. Years down the line, many of our Rule Breakers stock recommendations that seem "expensive" now will seem like ridiculous bargains. So go ahead and be a cheap investor if you must. Just realize that sometimes you have to pay up to buy the cheapest stocks.
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Longtime Fool contributor Rick Munarriz considers himself a bit of a spendthrift in the real world, but he realizes that you need to splurge from time to time to find the market's real bargains. He does not own shares of any company mentioned in this article.
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