A week ago, I asked you the musical question: "Would you buy the whole freakin' company?" Today, I'm here to tell you about a company I most definitely would not buy in its entirety, or even in part.
Yes, gentle reader, I've scoured the financial world to bring to you one of the most ridiculously overvalued stocks known to man. But that's not all. In addition to my pick for one of the most ridiculously overvalued stocks known to man, you'll also receive (at no additional charge), my patented "Not in a Million Years" method for uncovering these overpriced bad boys.
Finally, for everyone who reads this article in the next 10 minutes (it should only take you five, so stop complaining), I'll also throw in my advice for what to do with this overpriced stock, especially if you own it already!
Not in a million years
My "Not in a Million Years" (NiaMY) approach to finding overpriced stocks is simple: I merely look for companies whose valuations are so high it would take a million years to justify them relative to their peers. OK, OK, a million years is a bit extreme, but I needed a hip name for my theory to catch your attention.
The twist on this theory is that I assume the company in question will eventually be a "mature" player in its industry. That is, whatever super-hyper growth rate it currently enjoys will regress, and the company will at some point be valued similarly to its established industry peers.
I then ask myself one question: If the market decided to value the stock based on the valuations of its more mature peers, how long would it take the company to deliver enough revenue, earnings, or cash flows to warrant its current valuation? I know that's a mouthful, and a little hard to digest, so let's go to our example.
Ridiculously overpriced: Amazon.com
As great a company as Amazon.com is, the stock is ridiculously overvalued. The company trades at 4.5 times sales, is growing sales at 25% per year, and has a $21 billion market capitalization. Using my patented NiaMY method, we'll contrast Amazon.com with retail industry leader Wal-Mart
Logic dictates that, at some point in its future, Amazon.com will be considered a "mature" company; it will deliver steady and predictable, but not accelerating growth. (With the recent slowing of revenue growth, some might argue that Amazon is rapidly maturing as we speak.) At that point, whenever it is, I believe that Amazon will be valued similarly to its peers.
Not knowing how the market will view stocks then, I look for comparables today in the form of Wal-Mart. What kind of top-line revenue would Amazon have to be pulling in to justify a $21 billion market cap if the market only afforded it 0.9 times sales? To save you time on the calculator, it works out to $23.3 billion in sales.
Using Wal-Mart's 12.5% revenue growth rate as a proxy, Amazon would have to grow its top line at 12.5% annualized for the next 15 years to justify its current market cap! If that scenario plays out, and the market considers Amazon a mature retailer worth 0.9 times sales, the stock will have gone nowhere in 15 years.
It gets uglier
What kind of top-line growth would Amazon have to produce over the next 15 years to deliver 12% returns on the current stock price? Amazingly, Amazon.com would have to produce 26.6% compounded revenue growth for the next 15 years to deliver 12% growth in the stock's price.
I can guarantee you beyond a shadow of a doubt that Amazon cannot deliver 26.6% compounded revenue growth for the next 15 years. No way, no how. That doesn't take into account dilution from stock options. But that's another story. At $5 in late 2001, Amazon.com was a steal. At $52.50 in late 2003, it's one of the most ridiculously overpriced stocks around.
A problem and a solution
One of the biggest problems here is that some of you, perhaps many of you, already own Amazon. What should you do when you realize that a company you own is insanely overvalued? You could sell the stock, capture your profit, and go home happy. That's fine and dandy and I have no qualms with that approach. But, I'd like to lobby for the "stop-loss" for a moment.
For those of you who do not understand what a stop-loss order is, please refer to this article that explains it nicely.
The reason I like the idea of a stop-loss order instead of a plain old sell is because at any given point I could be wrong about at least two things: (1) the company's ability to deliver; and (2) the sanity of the market
It's always possible that the company I now think is grossly overvalued has something great up its sleeve to really change the picture and the potential valuation prospects. Because I don't know what I don't know, using a stop-loss order keeps me invested in the stock, but with a safety net.
The other wildcard is that the stock market has a funny way of driving stocks up beyond all reason, even further than what I might now consider crazy. In that case, a stop-loss order will help keep me in a stock so I can take advantage of the insanity of others. In Amazon's case, with the stock at $52, I'd personally set a stop-loss around $40 and keep raising it as Amazon.com continues to rise.
That way, if something great happens and the stock ends up at $100, you'll still be there with a trailing stop-loss order at $85 or $90. And if the market comes to its senses and the stock does drop back to $40, you'll be out with what we hope is still a tidy little profit. Your stop-loss order price will vary based on the amount of profit you're willing to risk.
Nothing is perfect
True, there are times when a stop-loss doesn't work perfectly to your advantage. Worst case, you could get stopped out at the worst possible time, but I'm generally in favor of them. After seeing many profits evaporate during the Great Bursting Bubble of 2000-2002, I realize I could have easily exited with much better results had I simply put stop-loss orders in place.
I hope my patented Not in a Million Years (NiaMY) approach to identifying overvalued stocks has at least got you thinking. I also hope you enjoyed my free pick for one of the most ridiculously overpriced stocks out there. If you read this article in 10 minutes, you also enjoyed my stop-loss order advice for how to deal with these high-wire acts.
Let me make you a final offer for today.
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David Forrest does not own any of the stocks mentioned in this column. The Motley Fool is investors writing for investors .
