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It’s not quite 20 years since the “dot-com boom” became the “dot-com bust,” but as the market extends itself into the longest bull market in history, it’s hard not to see some of the same characteristics between the stock market in the years leading up to that crash and this one. The tech industry has been the leading sector in the marketplace for most of the last several years, and it seems like just about any tech or internet stock with an interesting story to tell, and a big enough subscriber base is seeing its stock price pushed to one high after another.
The rhetoric around tech stocks today is also eerily similar to the popular talk and analysis of the industry two decades ago. In the late 1990’s, the market was abuzz with the promise and potential of the World Wide Web to transform business and commerce. Because companies working in this cutting-edge, revolutionary technology were breaking ground that nobody had ever seen or encountered before, a lot of analysts dismissed traditional valuation and fundamental measurements in judging their worth. The argument was that the metrics for these kinds of businesses had to be different; instead of looking for whether or not a stock was actually generating revenue or actual profit, a lot of stocks were judged almost exclusively on the basis of how much traffic they could generate to their web site.
Take a little time to pay attention to the experts talking about companies like the FAANG stocks -Facebook (FB), Apple (AAPL), Amazon (AMZN), Netflix (NFLX), and Alphabet (GOOGL– formerly Google). FAANG is the acronym originally coined by Mad Money host Jim Cramer to describe these companies a couple of years ago that has since become a central point of reference for the tech industry at large. Each company is an acknowledged leader in their respective business space, but it seems like in each case, analysts point to metrics that don’t get applied to any other kind of business. NFLX has shown negative free cash flow in each quarter for the past four years as they load up on debt to pay for original streaming content, but the experts only seem to care about how many subscribers they have and how many hours those subscribers spend binge watching. AMZN operates with razor-thin operating margins, but the dominant conversation piece about that stock is what kind of business they will branch into next.
To be clear, I’m not trying to analyze the fundamental strength or weakness of any of these companies with this article; instead, I simply want to apply some basic valuation measurements against the prices of these stocks, because I think that while these companies are proving that doing business in a different way than most are used to can, and does work, I think that the market is letting that logic extend to their respective stock prices in a way that is making them more and more risky to the average investor. Remember that when the bubble finally burst in 2000, a lot of Internet stocks that many thought were going to be around forever simply disappeared, leaving everyday investors like you and me holding nothing but an empty bag. In the same way that otherwise conservatively-designed mutual funds began overweighting their portfolios in tech and Internet stocks, an increasing number of money managers seem to have thrown caution to the wind in the last couple of years to jump on board the FAANG bandwagon.
The argument now is almost the same as it was then, with a slightly different twist: there seems to be plenty of opportunity to grow into the future as emerging technologies like cloud computing, social media, artificial intelligence and big data are to today’s market what the World Wide Web was twenty years ago. That might be true, just as the emergence, relevance, and importance of online business and commerce in every sector of the economy has proven itself out – but that doesn’t mean that there aren’t risks, or that prices won’t correct. Remember that when the recession hit in 2000, it took nearly two years for the market to recover; that difficulty certainly extended throughout the tech industry. Smart investors use the past to provide perspective about both the opportunities and risks that the current market can represent, which can help you differentiate between speculation and investment more effectively than you might do by simply following the crowd.
In his writings to shareholders, Warren Buffett has often referred to Book Value as a way to measure the actual per share value of a business. He has often described it as the amount of money a shareholder can expect to be paid if the business were to halt operations, liquidate its assets, pay off its liabilities, and permanently close its doors. Since most stocks in the market today – not just tech stocks – trade at a multiple of their Book Value above 1, I like to expand that analysis to factor their current Price/Book ratio to their historical averages; that gives me a way to judge how much above the Book Value investors usually let a stock run under normal circumstances. Today I ran through a simple comparison of the current stock prices of all five FAANG stocks compared to their respective Book Values and historical ratios. Here’s what it looks like.
Facebook, Inc. (FB)
- YTD Performance: -2.02%
- Current Price: $172.90
- Book Value: $27.33
- Current Price/Book Ratio: 6.32
- 5-year Average Price/Book Ratio: 8.3
- Target Price: $226.83
- Difference from current price: +31%
FB is the only stock from the five that is currently trading below its historical average Price/Book ratio, which also implies that the stock could actually be undervalued right now. FB has some interesting strengths, including healthy Free Cash Flow, little to no debt, but has also been hamstrung this year by fallout from data leaks and pressure from U.S. and international regulators over the way it deals with fake news and customer data collection and sharing. Those are concerns that don’t seem to be abating quickly, so the stock could continue to remain under pressure for the foreseeable future despite its current relative discount.
Amazon.com, Inc. (AMZN)
- YTD Performance: 62.17%
- Current Price: $1,902.90
- Book Value: $71.75
- Current Price/Book Ratio: 26.52
- 5-year Average Price/Book Ratio: 20.52
- Target Price: $1,475.18
- Difference from current price: -22.4%
Long gone for AMZN are the days of simply operating as an online bookstore; this is a company that has expanded its reach into multiple different business segments – e-commerce, cloud computing and storage, video and music streaming, grocery, to name just a few – to the point that it really defies description as just a tech company. Their ambitious and aggressive approach to expansion and maximize growth includes a willingness to work with tiny slivers of margin as long as they can get volume and scale. It’s clearly working, but the risk here in my opinion comes in investor’s willingness to drive the stock to incredibly high premiums to what that business is actually worth. If and when that opinion shifts, the stock could be in for a drop much bigger than what is reflected here.
Apple Inc. (AAPL)
- YTD Performance: 27.34%
- Current Price: $216.37
- Book Value: $23.39
- Current Price/Book Ratio: 9.25
- 5-year Average Price/Book Ratio: 5.18
- Target Price: $121.16
- Difference from current price: -78%
Like AMZN, AAPL has transformed its business over the last twenty years. No longer are they simply the manufacturer of Macintosh computers – they redefined the music industry with iTunes and the iPod and made cell phones and tablets nearly as powerful and functional as laptop computers. They certainly deserve their long-held place among tech leaders, but questions about their ability to keep innovating persist as the iPhone matures and competitors like Android continue to make inroads and capture market share from their once-absolute perch atop the smartphone market. The company continues to be highly profitable, and investors have been rewarded with rich returns on their shares; but seeing the stock trading nearly twice as high as its historical Price/Book average has to raise doubts to those thinking about taking a new position in the stock.
Netflix Inc (NFLX)
- YTD Performance: 62.17%
- Current Price: $339.17
- Book Value: $10.33
- Current Price/Book Ratio: 32.83
- 5-year Average Price/Book Ratio: 19.78
- Target Price: $204.33
- Difference from current price: -39.7%
Perhaps more than any other FAANG stock, NFLX really tends to defy conventional fundamental standards. While the company has shown impressive growth in earnings since early 2016, they have also operated with negative free cash flow and the highest level of debt among all of its FAANG brethren over the same period. Since free cash flow is harder to manipulate than earnings per share, many analysts, myself included, prefer it over earnings as a more accurate measurement of a company’s profitability. NFLX’s ongoing logic and explanation of its ever-increasing debt is that profitability will eventually be seen as long as user subscriptions keep growing. Investors have always tended to price their perception of a stock’s future prospects into its current price, but in NFLX they seem content for the time being to extend that perception into a much longer future point in time than normal.
Alphabet Inc. (GOOGL)
- YTD Performance: 15.93%
- Current Price: $1,221.16
- Book Value: $232.78
- Current Price/Book Ratio: 5.24
- 5-year Average Price/Book Ratio: 4.36
- Target Price: $1,014.92
- Difference from current price: -16.8%
GOOGL doesn’t tend to dominate headlines the way many of the rest of its FAANG brethren do; but this is another company that has moved far beyond its early beginnings as a search engine company. They built the framework for the Android operating system that now stands toe-to-toe with AAPL’s iOS as the dominant mobile operating system, and have branched successfully into cloud computing and storage (think Gmail, Google Docs, Google Drive, and so on), digital music and video commerce (YouTube and Google Play), and even social media (Google +). Like AMZN, they are also on the cutting edge of innovative new technologies, like self-driving (Waymo) and are even competing with Internet Service Providers (ISPs) all over the country with Google Fiber. Like all the FAANG stocks, their ability to drive innovation and grow their business has translated to fantastic returns for shareholders; but while they may not be as overvalued as some of its brethren, it nonetheless is trading at a significant premium above its historical Price/Book ratios.
None of this, of course, is a guarantee that these stocks are doomed to start dropping immediately; however a smart investor thinks carefully about what kind of risk a new position could expose your portfolio to, especially when the market has been performing so strongly for such an extended period of time. Stocks trading at or near all-time highs as the FAANG stocks generally are right now are the ones that tend to hurt investors the worst when the economy and the markets swing back in the opposite direction, no matter how strong their underlying business may be.