What's ABC company worth?

How can we know what a stock is worth?

I was talking SHOP with a friend of mine and he put it this way: “Why does SHOP have to be worth $100?” In other words, why is $80 or $60 or $40 cheap? I think that’s a good way to put it, because stock prices can seem entirely arbitrary if you don’t know much about fundamentals, or when the fundamentals don’t apply in the way you’re used to.

I didn’t want to get into discounted cash flow analysis, because that’s not how I look at stocks anyway. Of course I look for rapid growth companies, but what about valuation? Why do some rapid growth companies (HDP) have a PS of 4 and some (SHOP) have a PS of 17? Here’s how I answered him:

Great question. Probably better answered with an entire seminar, but the gist of it is that what the stock is worth is relative to other comparable stocks. I typically measure growth stocks by the price to sales (PS) ratio. SHOP’s is at about 17 which is the highest of any stock I own. But its revenue in the March quarter was 75% higher than the March quarter last year! Most of my companies average ~40% YoY growth, and even that is incredible. Their PS ratios average around 9 or so.

So yes, SHOP is expensive. But it’s amazing how fast that PS comes down when it grows as at the rate that it does. If they achieve their target in the June quarter, which they will probably beat since they always beat, their PS ratio will be below 15 immediately, at the current price. That’s how fast it can come down. If it continues growing at that rate for several ?quarters, it could turn out that today’s price was actually cheap and just LOOKED expensive.

Also, it’s not losing tons of money like Hortonworks (PS under 4), and its business isn’t threatened as much as Yelp (PS ~3). So it’s not just that it’s growing faster, but that the market has a lot of confidence in its business and growth. For what it’s worth, The business threats Yelp faces are more concerning to me than the money Hortonworks is burning.

Still, it is crazy that I can’t set an absolute value on it, that it has to do with where other stocks are trading and the market’s sentiment. But whether my average stock’s PS ratio is 9, or 6…that’s all stuff I can’t control…that’s all short term. In the long term if a company grows, the stock will too. That’s why I focus on that relative value between stocks that I like. I like them all, and others too, but I try to go biggest on the ones with the biggest potential to keep growing incredibly…unless they just get so expensive I can’t understand it.

Bear

8 Likes

Bear,

I’d be careful with the following comment.

If they achieve their target in the June quarter, which they will probably beat since they always beat…

Yes, they always beat…until they don’t, and when that does eventually happen, the result is usually pretty ugly.

Now it hasn’t happened yet, and I’m not saying to invest in them as though it will, but, past performance is not indicative of future…blah, blah, blah.

2 Likes

Hey Bear,

The three basic business valuation approaches are:

Cost Approach: How much would it cost to build this business’s assets from scratch (or conversely, sell them piece by piece)? This is largely a fair value accounting exercise that drastically underestimates the value of a going concern. It’s used mostly in liquidation contexts or as a floor value of a going concern that’s not so valuable under either of the next 2 valuation methods. (For example, if all the pieces of the business can be sold for $1M, but the Income and Market Approaches yield a lower value, you can’t tell the IRS the business is worth anything less than $1M.)

Income Approach: What is the value of the future income this business will generate? This is most often the dreaded and much-maligned DCF … which I believe should never be taken as gospel, but should be done as a sanity check on the next valuation method, to vet what assumptions would have to be true to justify multiples, etc.

Market Approach: How much is this or a substantially similar business selling for in an open market? For publicly traded companies, this is generally its market cap. This is also where all the Price-to-[Sales, Earnings, EBITDA, fill in the blank] ratios come from for public companies. Can be very useful in comparing similar companies … not always good at giving insight on why multiples vary. Plus, if a market is irrationally exuberant or otherwise inefficient, this valuation method can lead to some surprises down the road. The market is willing to pay X … right up until it isn’t.

They call me,
MrTBS

7 Likes

Hi Paul,

I’m far from an accountant, but I’ve had some accounting classes in college and always use financial statements in my due diligence. There are lots of methods to use for valuation and lots of data available. I’ve found what works best for me is to combine as many methods as you can (I find time to be the big constraint here-how much time can we devote to valuation for a single company?) and compare them to other similar companies if there are any.

But any method requires forecasting the future and like Yogi said, it’s especially hard before the future’s here. When you take a company with a long history, it’s normally not too difficult to make reasonable forecasts of sales and profit growth, even with new products in the pipeline, because you can use history as a guide and make adjustments as you see fit without the adjustments needing to be too crazy or far-fetched. That’s why many people don’t invest in tech; it moves too fast, it’s like quicksand, always changing. Even Buffett, whom some would say now invests in tech so far has only invested in companies that have not only a great track record, but a very long one. He got rich that way, by always having a historical knowledge of a company’s record. Nothing wrong with that, and if you can catch a company that’s “only” growing at a 20% clip when their price is lower than average, our returns could be as high as with many tech fast growers. But those are rare these days, or someone is hiding them from me.

With Disrupters like VEEV or SHOP or YOUNAMEIT, we have none of that. We have “expert” opinions, from people with many differing influences and agenda and we have bs from bloggers galore and opinions. Our opinions, our friends’ opinions, opinions from friends at TMF, whatever. But that’s all we are ever going to have until the future becomes the present (that’s good for about 1 day) and then the data is history that anyone can explore.

How can we value a firm? Any way we want, but with confidence? Without some insider knowledge or Secret Sauce, the only way is to have confidence in our own projections of future sales, earnings, reputation, industry changes, technological developments and so on, and how those changes will affect the company we’re considering. Not so easy now; we have little history, charts aren’t much help, and opinions vary from tech company’s becoming The Next Big Thing to Shortify and everything in between.

So for the types of companies we’ve been discussing here, I’ve come to a conclusion at least somewhat similar to yours in that any forecasts made with a reasonable level of confidence must involve sales first, especially in low-overhead areas like software. Sure, they need office space and equipment and some of the many things that most solid businesses need, but they don’t need to build the world’s largest production facility to build chips. For many of these companies I also want to add cash requirements in the mix, so I look at cash flow from different angles to see what could/should happen. With society being what it is today, I also find the need to make some kind of forecast for the longevity of the need and value of the product. Seemingly stable firms are now going out of business every week. Entire industries are appearing and disappearing and much of what we thought we knew in 2007 is already obsolete. We used to go to stores to buy shoes, clothes and household supplies. Who among us thought that would come to an end ever, let alone in a couple decades?

So many of us didn’t see the sudden shift in retail, one of the simplest sectors in existence. Now let’s shift the discussion to the things we’re looking at for future growth. What about the cloud? And how about Big Data, or computer guided vehicles? Or drones! And oh! Artificial Intelligence, it’s going to be huge, you say!

Okay, but for how long? Who can afford it? What industries will be re-shaped by these things? Which ones will disappear? What new ones will come into existence? What happens to medicine when 90% of cancers are cured? What happens when genetic . . .

Argh, you’re right. Valuation is hard because forecasting is hard. But hey, that’s what pays the big bucks. Or so I hear.

Dan

4 Likes