For companies like Apple (AAPL 1.14%), measuring its valuation -- the relationship between stock price and earnings per share of stock issued -- is pretty straightforward. The company consistently generates positive earnings each quarter, making it easy to calculate a price-to-earnings ratio -- a financial metric that is often used in determining whether a stock price is a fair value. Apple is a mature company well into its business lifecycle, and has a history that helps in determining its value.
But not all companies are like this.
Some are too young or still ramping up operations and don't have positive earnings yet to measure, which forces investors to seek out other, more creative financial metrics for evaluating whether the company is a good buy or not.
Let's take a closer look at a couple other ways to evaluate stocks, using the endpoint cybersecurity company CrowdStrike Holdings (CRWD +1.07%) and Apple as our differing examples.
Image source: Getty Images.
Valuations are nice, but trends are important too
When a company doesn't have years of earnings results for investors to evaluate, turning to profit trends becomes an important alternative.
For example, CrowdStrike began issuing stock in June 2019. In its most recent quarter (which ended July 31), it announced positive net income and positive cash flow for the very first time. One quarter of results isn't enough to generate a useable price-to-earnings ratio, so alternative considerations need to be used as part of evaluating the stock. One option is to take these initial results and annualize them (i.e. multiple by four). Doing so suggests that CrowdStrike trades for an earnings P/E of 1,040. Annualized calculations also suggest the company trades for a triple-digit free cash flow ratio of 207.
When comparing this annualized valuation to Apple's latest quarterly earnings P/E of 34 and its free cash flow multiple of 28, CrowdStrike looks extremely overvalued. Using this metric on its own, it appears that pricey CrowdStrike is simply not a good investment because it's stock is comparatively too expensive. But other factors need to be considered as well for a fair evaluation.
It would be one thing if a company's expensive valuation coincided with no growth or even modest growth. But if the growth and business plan execution of a company is apparent, a lofty valuation can be more palatable to a would-be investor. In CrowdStrike's case, its most recent earnings and free cash flow figures grew by 117% and 210% year over year, respectively. In comparison, Apple's earnings grew by 18% year over year. For investors, outsized growth will often coincide with higher valuations because it serves as a clear signal of strong demand for what the company is offering. This is more likely the real reason for CrowdStrike's and Apple's valuation gap.
The two companies are at different points in their industry life cycles. For Apple, computers, smartphones, tablets, and smartwatches have been around for several years now and the demand has begun to level off. For CrowdStrike, endpoint computer security is a young and rapidly growing industry; it will likely take years of expansion before success translates into a leveling off of demand for these products. When considering this, the wide difference in valuations is more understandable.
Not factoring in this reasoning into your stock evaluation can lead investors to miss out on buying stock in newer companies with compelling potential for upside.
Studying the margins
Beyond improvement in traditional profit metrics, it's also important to study a company's margin profile. When margins expand over time, it provides evidence of a company becoming more efficient and therefore raising its profit potential. If an executive team is talented in allocating capital, a margin profile should continue to improve or stabilize over time.
Supercharged growth is great, but it's also somewhat meaningless if profitability is worsening at the same time. Growing revenue while allowing margins to fall is a lot like spending a dollar to buy $0.95. Conversely, expanding margins is direct evidence that a company is realizing a positive return on the dollars it is investing back into the company.
Sticking with our CrowdStrike example: From the company's fiscal year 2017 to today, it has more than doubled its gross margins from 36% to 75%. Such notable gross margin expansion coinciding with the company's impressive 120%-plus revenue retention is an explosive combination that will likely boost profitability over the long-term.
Just like rapid growth in revenue is often greeted with higher valuations, quickly expanding margins also tends to boost a company's valuation ratio. For comparison, Apple's gross margin of 21.3% is pretty stable (as it is with many mature companies) and offers solid reasoning for a more modest valuation.
The takeaway
While a price-to-earnings ratio is a useful metric for evaluating a company, it really does not tell the full valuation story. For younger companies working toward profitability, solely focusing on price to earnings is a great way to miss out on potentially fruitful investments. Instead, consider widening the scope of your research to get a more complete picture of the true value of a specific company.
