The past two months have been nothing short of brutal for investors, with the stock market responding to the unprecedented coronavirus disease 2019 (COVID-19) pandemic. With nearly a third of all global COVID-19 cases originating in the U.S., stringent mitigation measures were needed to slow disease transmission, leading to the shutdown of nonessential businesses. This nosedive in economic activity is what's behind the S&P 500's 34% swan dive in less than a five-week period.
During bear markets, it's not uncommon to see high-flying stocks, growth stocks, and those with high price-to-earnings (P/E) ratios take it on the chin. This would include the so-called "FAANG stocks" that have pretty much led the market higher for much of the past decade.
Based on traditional metrics, the FAANG stocks look expensive
By FAANG stocks, I'm referring to:
- Facebook (META -0.39%)
- Amazon (AMZN -2.78%)
- Apple (AAPL 0.00%)
- Netflix (NFLX -0.90%)
- Google, which is a subsidiary of Alphabet (GOOG -1.62%)(GOOGL -1.81%)
These companies are absolute game changers, innovators, and market-share mavens in their respective fields.
- Facebook is home to four of the seven most-visited social platforms in the world.
- Amazon's e-commerce accounts for 38% of all U.S. online retail sales.
- Apple has a cult-like product following, and the iPhone is the best-selling smartphone in the United States.
- Netflix is the streaming disruptor with 183 million worldwide subscribers.
- Alphabet's Google holds 92% of the world's search market share.
They're also generally considered to be pricey by traditional metrics, such as the price-to-earnings ratio. On a 12-month basis, here are the trailing P/E ratios for all five FAANG stocks:
- Facebook: 28.4
- Amazon: 102.7
- Apple: 21.9
- Netflix: 85.3
- Alphabet: 25.7
With the benchmark S&P 500 at a trailing P/E ratio of closer to 20, and investors clearly eyeing value after a record-breaking decline in the market, none of the FAANG stocks looks to be particularly attractive based on this most common fundamental metric.
Cash flow is a much better value indicator for determining FAANG stock value
Traditional fundamental metrics aren't the best way to measure "value" in FAANG stocks. That's because all of them reinvest a significant portion of their cash flow back into their core businesses, as well as use this operating cash flow to fund new ventures. Some of these ventures actually turn into incredible growth opportunities.
For example, Amazon's cloud-service operations, Amazon Web Services (AWS), has quickly grown to account for 12.5% of the company's total sales. Likewise, Google Cloud sales have jumped by 120% since 2017 to almost $9 billion annually. As for Apple, its focus on wearables and services have led to a sustainable double-digit growth rate in both categories.
Because FAANG stocks aggressively reinvest their operating cash flow to maintain their competitive advantages, grow their reach, and fund these new ventures, cash flow, not earnings per share, makes for a far better indicator of fundamental attractiveness for them.
The interesting thing is that, when looking at these five game changers from the perspective of cash flow, most look downright cheap.
Amazon, Alphabet, and Facebook look especially cheap... Netflix, not so much
The real standout of the group is Amazon, which has historically been valued at 23 to 37 times its cash flow over the past decade. However, according to consensus estimates from Wall Street, Amazon could see its cash flow per share nearly triple to $201 by 2023 from $76 in 2019. Thank AWS for this explosion in operating cash flow, given that cloud margins are multiple times juicier than retail and ad-based margins.
This would place Amazon at close to 12 times its cash flow if these estimates prove accurate. If Amazon simply kept to its historic cash flow multiple, we're talking about a company that could easily hit $5,000 a share by 2023.
Another historically cheap business is Alphabet. Consistent search-based ad growth -- compounded with flattening traffic acquisition costs, rapid YouTube ad-revenue growth, and Google Cloud growing into a larger percentage of total sales -- should push cash flow per share to $122 by 2023, up from $78 in 2019. For a company that's averaged a price-to-cash-flow ratio of 17.8 over the past five years, this 2023 estimate suggests a multiple of just over 10. Simply sticking close to this historic multiple could put Alphabet near $2,000 a share by 2023.
Even Facebook is at the lower bound of its historic cash flow multiple. The social media giant's average price-to-cash-flow ratio was 25.5 over the past five years, and Wall Street has it pegged for $13.55 in cash flow from operations in 2021. That's a multiple of 13.5 for next year. Mind you, Facebook hasn't even flipped the switch yet to monetize WhatsApp or Facebook Messenger, and it's already this inexpensive.
If you're wondering about Apple, it's right in the middle of its historic range relative to operating cash flow.
At the other end of the spectrum, Netflix doesn't look cheap, even after blowing away Wall Street's subscriber estimates in the first quarter. Despite generating a profit, Netflix has been reinvesting heavily in overseas expansion and original content -- so much so that it's been burning through cash at a precipitous pace for years.
Even though its cash outflow is expected to be lower than expected in 2020, the company's first-quarter report still suggests up to $1 billion in cash outflow this year. Thus, based on both P/E and cash flow, Netflix is a pricey stock.