Redefining What "Overvalued" Means When It Comes to Stocks

Investors who only want bargains miss out on the winners that will keep winning.

Motley Fool Staff
Motley Fool Staff
Aug 15, 2019 at 9:38AM
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Value investors -- like the great Warren Buffett -- seek out temporarily underpriced assets. Theirs is among the more popular investment philosophies, because "buy low, sell high" makes simple, intuitive sense. But as Motley Fool co-founder David Gardner discussed in detail in an earlier Rule Breaker Investing podcast, quite a few of the best performers in the Rule Breaker portfolio were recommended at times when -- by traditional measures -- they looked overvalued. This, of course, is because Gardner is guided by the idea that winners tend to keep winning, so buy them high, and let them run higher.

Well, the listener whose question originally inspired that episode is back with a follow-up: Fine, says Darren Pryor, a stock that is by some metrics trading at nosebleed levels still may be a buy...but how, then, should we really define "overvalued" when it comes to stocks? There has to be some point where even a great company is just too pricey. In this segment from the mailbag podcast, Gardner brings back senior analyst Jim Mueller for a discussion of the varied ways that answer plays out, depending on the industry and other company-specific factors.

To catch full episodes of all The Motley Fool's free podcasts, check out our podcast center. A full transcript follows the video.

This video was recorded on July 31, 2019.

David Gardner: This one comes from our friend Darren Pryor. He writes, "Hi David and the fantastic crew at MF. Just wanted to say how chuffed I was when I heard this week's podcast only to hear you dedicate an entire show to my recent email. I couldn't wait to tell my wife and kids, who were equally excited and who've consigned that episode to our family heirloom. In the unfortunate circumstance of my untimely departure from the earth, they have promised to play that episode at my funeral to promote the kindness of one David Gardner." Now, that is over the top Darren. I'm going to just urge Darren's family, please don't do that. There are so many more important and wonderful things to say.

Jim Mueller: And may that possible passing be long in coming.

Gardner: Thank you very much! Darren goes on, "I very much appreciate the in-depth and thoughtful analysis that went into my question, which helped me immensely on the one hand, but also left me with another question on the other. Many of the examples you highlighted in the podcast -- Trade Desk, Netflix, Intuitive Surgical, MercadoLibre -- were indeed trading at 'nosebleed levels' back then. However, such price-to-sales ratios afforded to those stocks back then would seem today to be darn right cheap in comparison." He cites some cases in point -- companies like Zoom, Slack, Okta. He says his favorite, Beyond Meat, trading recently at 90-plus times sales. So, Darren presses the point a little bit further, Jim, and we're going to have a conversation now about it. At what point do such shares become just too expensive? If he can get 94 times sales for his business, he'd buy David Gardner, he says, his own personal Tesla factory as a thank you for my guidance. "Cheers, David and MF team. Darren Pryor, writing from the Gold Coast of Australia."

Mueller: Especially when value investors like Buffett, and one of my favorites, James Montier of GMO Capital now, say that buying something at more than one or two sales is outrageous. And I can certainly understand that. But a lot of it, I think, depends on what type of business you're buying. If you're buying Ford or GM at 90 times sales, run away!

Gardner: Good luck!

Mueller: I don't think it's ever been priced that high.

Gardner: Yeah, not anywhere ever, ever close.

Mueller: Right. But they're a big manufacturing company, so the price-to-sales ratio is good for that. But when you're a company that isn't asset-heavy, and a lot of the names you mentioned are asset-light and internet-enabled, they can generate a lot of revenue off of just a little bit of work and a few people. So, a higher price-to-sales multiple might be more warranted.

Also remember that the market is forward-looking in that it is expecting more of these companies going forward, and the company is expected to grow its sales at a healthy enough clip to justify such a high price, such a high multiple.

Gardner: Jim, you and I are the first to say, we could be at a market top here in July 2019. It may be that two years from now -- I hope this podcast is still around, and if the market's been really weak, then we'll say, "Yeah, that was a little crazy there. Ninety-four times sales for Beyond Meat," which I think you and I both do think is crazy for Beyond Meat.

Mueller: Yeah. They really haven't proven their model yet. But for longer-standing companies where they've proven their model, such as Netflix, and they can grow their sales 20%, 30% a quarter, year over year, quarter in and quarter out, they probably are justified to have a higher price-to-sales ratio. Then the debate becomes how high or how low.

Gardner: Right. And that's where we are right now. And certainly, when interest rates are very low, that's always going to raise up the price per sales, price per earnings we're willing to pay for stocks, Jim, because if we're getting like 1% from our bank account, or just a few percentage points from our bonds, we're all going to say, "Well, I'd rather buy some stocks," and that's going to press prices up.

Mueller: That is definitely true.

Gardner: So I think part of what you're saying, Jim, is not all companies are created equal. Ford will, alas, never for Ford and its shareholders ever trade at probably even 15 times or 20 times sales, let alone 30 times sales. And yet, asset-light businesses can go very high, even though they might be too high right now.

Mueller: I'd like to mention one other point. Remember, all of these ratios are just shortcuts of the valuation -- price to earnings, price to sales, EV to EBITDA, whatever metric floats your boat. It's just a shorthand to a valuation. An investor should hopefully be looking at the company and understand the company, how it makes money, what levers it can pull, and where it might grow, and what its optionality might be, and thus get a better sense of what is possible with the company, and whether that high multiple might actually be warranted, or a bit on the stretch side, or even blowing-out-the-water overvalued.

Gardner: Absolutely. Jim, it reminds me to double underline that point about, I think, especially beginning investors, they're taught to look at ratios and then not have much nuance from one industry to the next.

Mueller: Exactly. Different industries will have different ranges of ratios that are appropriate for that.

Gardner: That's right. Here's a helpful thing to look at, Darren Pryor, and I'll add in James Chen, who sent in a similar note when he said, "As the episode played on, I found myself almost shouting out loud, 'That wasn't expensive back then!'" Indeed, a cursory glance at his own portfolio, James Chen says, "will show that many positions are trading in the price to sales of around 30, which was three times higher than Intuitive Surgical," which we featured in that episode a few weeks ago, which was the highest of the price of sales ratios of the ones we featured back then.

A helpful number that I think a lot of us should take a look at is, look at sales divided by number of employees. Jim lightly referenced earlier. Some businesses, to generate a billion dollars in sales -- let's say manufacturing, selling cars -- need tens of thousands of employees to do that. Other businesses can generate $1 billion in sales thanks to the internet and digital with only a few hundred employees. There's a huge difference between those types of businesses and therefore how willing we should be to pay up, Jim, or not for their stocks.

Mueller: Most definitely. And that, again, ties into the different types of industries that you're looking for, and what might be appropriate for one industry or one type of business or one type of business model is not appropriate for another. A SaaS company, a software-as-a-service company, probably is justified with a higher price-to-sales or price-to-earnings ratio than a retailer such as -- I want to say Le Bon Marche, but they're not public anymore -- Nordstrom for instance, or a car manufacturer, or a dam builder, a power plant builder.

Gardner: Yeah, infrastructure.

Mueller: Those all have their own different kinds of ranges. One thing that many people like to do there is compare companies to others in their industry, and see if one is mispriced one way or the other. But there, the assumption is --

Gardner: That they should all be the same.

Mueller: Well, that, and that the market has correctly priced all the rest. Maybe they're not pricing the rest correct and they priced yours correctly. So, be careful with that, too.

Gardner: Good. To close up, then I'll move to No. 3, I just want to say to Darren, to James, and to everybody listening, that I don't spend a lot of time guessing where the market is in its cycles. A lot of people who do have been consistently wrong. I say every year I think the market's going up. Good news -- I'm right two years out of three, which is a much higher batting average than most investment prognosticators. What I will say, though, is that we benefit from investing every paycheck, every month, in good markets and in bad. And often, you'll only figure that out years later. So, dollar-cost averaging with your savings and not guessing market cycles, or, are stocks high right now or not, for me, is not only a stress-free approach, it's actually much more likely to give you success over time as an investor. Jim, I know that you regularly save and invest every single month.

Mueller: Oh, definitely. I put money in my 401(k) every month. I don't put money into my wife's and my IRAs every month. I want to raise one more point, if you don't mind, about behavior. Be aware of hindsight bias. One of your emailers said something about looking back, that wasn't expensive. But at the time, with the knowledge he knew then, it might very well have looked very expensive, and only now that we have more knowledge about what happened can we look back and say, "Oh, of course that's what was going to happen." No, that's not the case. You don't know what the future is going to be until it actually plays out. That ties into your point about investing regularly. If you try to invest when the market is down and sell when the market is high, well the market might surprise you. It might go down further and you should have waited, many people think. Or, you don't [want to] invest when it's high; well, the market continues higher, so you would have gotten a better price buying a "high price" anyway.

Gardner: Yeah. Well put, Jim! Important words.