Remember when Starbucks (Nasdaq: SBUX) could do no wrong? No matter how many outlets it opened, however close to one another, Starbucks seemed capable of growing its business rapidly enough to keep pace with that rapid expansion.
Until it wasn't.
And at that point, as its growth slowdown became evident, Starbucks' stock transformed from market hero to market deadbeat. It was the same great company, making the same well-loved products for the same devoted consumer base, but its shares got significantly cheaper.
It happens all the time
The Starbucks story is nowhere near unique. Remember the technology bubble and its darlings Cisco (Nasdaq: CSCO) and Intel (Nasdaq: INTC)? Both titans are still trading at around a quarter of their bubble-level peaks, despite being more profitable today than they were during the height of the market's euphoria.
If you got caught up in the belief that those bubble-level valuations were reasonable, you weren't alone. When you've ridden wildly overpriced shares all the way to their current dizzying heights, it's easy to get distracted from the valuation reality by your apparent paper wealth. Even the venerable Warren Buffett did nothing when he found himself holding onto overvalued shares of Coca-Cola (NYSE: KO) -- which still trades significantly below its all-time highs.
Starbucks, Cisco, Intel, and Coca-Cola aren't exactly fly by-night companies, either. They're all recognized global leaders in their respective industries, and they're all followed by multiple analysts and millions of investors. If even their stocks can hit outrageously high valuation levels, it can happen to any company.
These days, however, all four companies' shares reflect a much more reasonable reflection of their prospects. Their businesses have continued to perform well, even as their stocks fell from their peaks. Over time, a great company's stock will reflect its true value, even if you can't precisely predict when that will take place.
Are there expensive companies today?
Those titans hit their peaks in a more euphoric time, amid a much more free-spending economy. These days, the market is at a significantly cheaper valuation in general, growth expectations are lower, and consumers and investors are pinching more pennies.
Still, even today, when the market gets the idea that a company is one of today's darlings, it can price that business's shares far above their true intrinsic value. Take a look at these companies' shares, for instance:
|
Company |
Forward P/E |
Trailing P/E |
Price-to-Book Value |
|---|---|---|---|
|
Equinix (Nasdaq: EQIX) |
73.5 |
77.3 |
2.4 |
|
Robert Half International (NYSE: RHI) |
55.3 |
81.8 |
4.1 |
|
WebMD (Nasdaq: WBMD) |
67.7 |
44.8 |
4.0 |
Source: Capital IQ, a division of Standard & Poor's.
Equinix certainly may have a very rosy future, as companies move to cloud computing, but it's still trading at more than 70 times next year's expected earnings. Likewise, Robert Half is a clear leader in the temporary staffing business, and WebMD is well-positioned to thrive as medical information goes electronic. But for how many years in the future must all these companies execute perfectly before they're worth what they're fetching in the market right now?
Can you do something about it?
When faced with a company that appears richly valued, you've got three basic options:
- Buy and hope that either the company grows into its valuation, or you can find someone else to unload your shares at an even higher price,
- Watch and wait to see whether you can buy that great business at a decent price later, or
- Sell first and look to buy back the shares later at a lower price.
That third option -- shorting the stock -- is not for everyone. After all, irrational pricing can persist for quite some time, and unless you have the strategy, the mind-set, and the capital to deal with that possibility, you can find yourself in a world of hurt. But if you want to profit from an overpriced stock, the most direct way to do that is to sell first, and buy it back cheaper later. Just make sure that the company is also facing operational or accounting difficulties, so that you don't get caught if the company continues to execute.
If you'd like to know more about shorting, enter your email in the box below. We'll send you our latest research the instant it's published -- plus, we'll also send you a brand-new, absolutely free report, "5 Red Flags -- How to Find the BIG Short," prepared for you by our resident forensic accountant, John Del Vecchio, CFA. Simply enter your email in the box below.
