Stocks with above average price-to-earnings (P/E) ratios, or those trading near their 52-week highs, aren't always expensive. The true test of whether a stock is cheap or not, after all, is the company's real-world ability to create value for its shareholders over long periods of time.
With this concept in mind, we turned to three of our Motley Fool investors to ask which stocks they think might be getting overlooked right now because of their unattractive valuation metrics, or recent surge in share price. They suggested Ionis Pharmaceuticals (NASDAQ:IONS), Shopify (NYSE:SHOP), and Intuit (NASDAQ:INTU). Below, our investors explain why they think these three stocks may be far cheaper than they may appear at first glance.
It's all about the pipeline
George Budwell (Ionis Pharmaceuticals): Traditional valuation metrics, such as price-to-sales (P/S) or forward P/E ratios rarely capture the true value of early commercial-stage biotech companies. The RNA-therapy company Ionis Pharmaceuticals, for example, comes off as insanely expensive based on its current forward price-to-earnings ratio of 752, but nothing could be further from the truth.
With literally dozens of drugs in development for a variety of high-value disease markets, this fledgling commercial operation arguably has a long ways to go before it can even remotely be considered "expensive." The real reason Ionis' valuation appears to be absurdly high, after all, is because the company actually licensed out its first major drug -- the spinal muscular atrophy medicine Spinraza -- to Biogen for a series of milestone payments and royalties on net sales.
Put simply, Ionis sacrificed a good chunk of Spinraza's commercial upside to shore up its balance sheet and to advance its highly diverse pipeline of RNA-based therapies. That's a fairly standard strategy among early commercial-stage biotechs, given the enormous expense of developing drugs, shepherding them through the regulatory process, and then assembling a sales force to bring them to market.
All told, Ionis has the potential to eventually generate tens of billions in revenue based on the commercial prospects of its pipeline that now sports a stunning 37 experimental drugs, as well as multiple late-stage product candidates. With a market cap of less than $7 billion at present, this promising biotech stock is arguably deeply undervalued right now.
A sales platform that's worth the sticker price
Keith Noonan (Shopify): Trading at roughly 18 times its forward sales estimate and having never turned a profit, Shopify certainly looks expensive. The company has delivered impressive sales growth so far, but even then, investors are paying a premium for the promise of its business. That tends to be a risky proposition, but sometimes it's one worth pursuing. With that in mind, I think Shopify's momentum and expansion potential actually make the stock cheap, even as it currently trades at all-time highs.
For those unfamiliar with the company, Shopify provides e-commerce platforms as a service -- allowing sellers to quickly launch and conveniently maintain online sales portals. It mostly caters to small- and medium-sized businesses. However, it also counts some larger brands, including Budweiser and Red Bull, among its customers. All told, the company provides service to over 500,000 merchants worldwide -- up from 165,000 roughly two years ago. That's an impressive reach for a young company, but it still leaves lots of room for expansion.
Last quarter saw revenues climb 75% year over year, and the company is doing a good job of growing sales relative to expenses even as it prioritizes expansion over near-term earnings. With Shopify's current customers more or less locked in, reducing its advertising and marketing expenses could quickly shift the company to profitability.
While Shopify's not cheap by the established guidelines of value investing, ownership involves a greater degree of speculation than some investors will be comfortable with. However, Shopify's current price could look like an absolute steal five years from now.
Forget profits, focus on free cash flow
Sean O'Reilly (Intuit): Intuit Inc. provides business and financial accounting-software solutions to small businesses, individual consumers, and accounting professionals. Its products include brand names like QuickBooks and TurboTax. Intuit's ProSeries and Lacerte are the company's tax-prep offerings for professional accountants. These products are practically indispensable today, and this simple fact makes Intuit Corp. a fantastic buy for Foolish investors.
Originally founded in 1983, Intuit's mission was to disrupt the paper and pencil accounting processes of corporate America and mom-and-pop small businesses alike. Intuit eventually branched out into -- you guessed it -- tax software, as well. Today, small businesses account for around half of revenues, individual consumers make up 42%, and professionals make up the balance.
At 38 times forward earnings per share (EPS) estimates, Intuit shares may appear expensive. But don't be fooled. The company's ability to generate mountains of free cash flow (FCF) more than makes up for an above-average P/E.
Accountants require businesses to depreciate assets and charge these depreciation and amortization costs against the income statement. This is a good thing, particularly for companies like steel mills that own assets that wear down.
However, it's somewhat misleading for companies like Intuit. Their primary asset is their brand name, reputation, and intellectual property. Generally accepted accounting principles (GAAP) mandate that the value of these things be estimated and depreciated nevertheless. For brand name, recurring-revenues businesses like Intuit, this can lead to some pretty big disparities between net income and FCF:
Shares may look expensive on a simple metric like price to earnings, but don't be fooled -- investing is rarely ever that simple. Any business with Intuit's growth record, business franchise, and FCF-generating abilities is worthy of consideration by any Foolish investor willing to look beneath the surface. In fact, at 23 times INTU's last-12-months' FCF, an argument could be made that its stock is downright cheap.
George Budwell has no position in any of the stocks mentioned. Keith Noonan has no position in any of the stocks mentioned. Sean O'Reilly has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Biogen, Intuit, Ionis Pharmaceuticals, and Shopify. The Motley Fool has a disclosure policy.