For some investors, valuation is everything they look at before purchasing a stock. While this has been a successful investing philosophy, it misses out on the biggest stock market winners. Why? Because stock valuations aren't artificially low unless there is some sort of pessimism around the company or the market. When a business is changing the world and multiplying, valuations can inflate and lead many to slap an "overvalued" description onto the stock.
Even high valuations can lead to extraordinary returns
Even if valuations are high, the stock can still provide market-crushing growth. A prime example of this is Nvidia (NVDA 0.76%). Nvidia makes some of the best graphics processing units (GPUs) used in gaming applications, data centers, and artificial intelligence. This exciting industry has led to massive revenue and profit growth over the past few years, with these metrics rising 147% and 249%, respectively, from Jan. 26, 2020 to Jan. 30, 2022.
Image source: Getty Images.
At the beginning of 2020, Nvidia was trading for 57 times earnings, a price many value investors would scoff at. Nvidia would get even more expensive as a stock, trading at a price-to-earnings (P/E) ratio above 80 for nearly two years and even crossing the 100 P/E threshold a few times.
NVDA PE Ratio data by YCharts
Now, its valuation has returned to where it started. But how did the stock fare during that same period when it was deemed "overvalued"? Pretty well, it turns out.
Even though Nvidia's stock currently sits 30% below its all-time high, it is still up nearly quadruple its original value in two and a half years, despite being "overvalued" for a period of time. Through sales and profit growth, highly valued companies can generate great stock returns. However, this isn't to say valuation is worthless.
Sometimes valuations get a little too high
Cloudflare (NET -1.47%) was another stock that saw massive attention during the pandemic. Cloudflare hosts and provides cybersecurity for websites on its cloud infrastructure. This stock received a ton of hype in 2021 and traded just over 110 times sales.
Earnings are the only way investors can eventually be rewarded, not sales. Cloudflare's long-term goal is to have an operating margin of 20%, which doesn't include taxes, so its profit margin would be even less in reality. For argument's sake, let's say Cloudflare can eventually generate a profit margin of 15%. At 110 times sales, Cloudflare was trading for an astounding 733 times future, non-existent company projected earnings. That's a bit absurd.
In 2021, Cloudflare grew its annual revenue by 52% year over year. At that pace, it would take Cloudflare six years of growth, without any stock appreciation, to match Nvidia's 57 P/E ratio.
| Year | Sales | Hypothetical Earnings (15% Margin) | Hypothetical P/E Ratio |
|---|---|---|---|
| 2022 (Company Projected) | $929 million | $12.3 million | 5,681 |
| 2025 | $3,502 million | $525 million | 133 |
| 2027 | $8,090 million | $1,213 million | 58 |
Data source: Cloudflare. Calculations by author. 2022 sales and earnings from Cloudflare's guidance.
To be clear: Cloudflare is not currently profitable, and this 15% profit margin uses future company projections. At its max of 110 times sales, Cloudflare's stock would have to stay the same price for six years and the company would have to maintain its current 52% revenue growth to reach nearly 60 times earnings.
Since it reached its peak, Cloudflare's price-to-sales ratio has dropped to 52. At this valuation, it would take over four years to achieve the hypothetical 60 P/E ratio. The current valuation is a high price, but much more reasonable than before.
Valuation isn't everything when determining what stocks to buy. However, investors must understand which valuation metric they are using when judging a stock's relative price. By mastering this technique, you can avoid purchasing stocks during periods of market euphoria, which may result in significant losses. At the same time, it will allow you to recognize that fast-growing companies can make expensive valuations look cheap.
