Valuation: The Broken Barometer

It’s a pro at dodging bull markets.

Stock market curmudgeons gravitate to value investing.

It looks like a smart money schtick, where wise elders gather and cluck their tongues at growth-chasing young-uns. Value’s metrics, and phrases like “reversion to the mean,” ring true. There’s something mysterious about the enterprise, this idea that somebody somewhere knows the true worth of something — and it ain’t you, so you’d better sit up and pay attention.

Trouble is, when it comes to stocks, there’s no such thing as true worth. There’s no intrinsic value, there’s no rule asserting that a value somebody labels “inherent” is the one that the collective crowd must settle upon, to say nothing of when it must do so. Reversions to the mean can take decades, and trends that require decades are fairly useless to mortals.

A back-of-the-napkin example begins this exposé on the right foot.

Amazon (AMZN $172 +13% YTD) has been accused of overvaluation since it went public in May 1997. In this nearly 27 years of overvaluation, the stock has appreciated 189,000%. A May 1997 investment of $10,000 in this absurd idea to sell books on the world wide web, and accept payments by credit card sight unseen, is today worth $18.9 million. The wise value mavens told you over the years of holding this overvalued clinker that you were an idiot for doing so. The historical record reverses that judgment back on those who eschewed the stock.

I could fill this report with dozens of valuation warnings about Amazon, but will zero in on one representative example. In August 2012, Saibus Research wrote:

By any standard measure, Amazon is overvalued. Amazon’s P/E based on expected 2012 EPS exceeds 300 and we already established that it is trading at over 100x expected 2013 EPS. … We’re glad that the investment community is so understanding because we are wondering when it will see its operating margins pick up. …

Amazon is overvalued and overrated. We believe that investors have bid this company up to an unsustainable high of over 100x expected 2013 earnings. We are also especially concerned that it is trading at over 34x TTM operating cash flows and nearly 100x TTM free cash flows. We see significant operational and execution risk in Amazon and are concerned that the recent run of rapid revenue growth has not translated into increased profits for Amazon. …

Being that Amazon is a technology company, it needs to maintain a strong stock price in order to attract and retain talent. Unfortunately, because the stock price is already so high relative to its earnings power, we believe that it will have a tougher time going forward with regards to attracting and retaining talent. … We think it would be prudent for investors to sell their shares at a gain and pay the maximum 15% tax rate rather than stick around for a significant potential decline in its shares.

That was August 2012. Here’s how AMZN performed by price afterward:

AMZN Price Change
After 8/1/2012
– – – – – – – – – – – – – – –
0% 3 months
13% 6 months
28% 1 year
37% 2 years
125% 3 years
317% 5 years
1114% 10 years

Through last Friday’s close, the stock is up nearly 1,400% since August 2012.

Thanks for the smart valuation warning, Saibus. That lagging operating margin sure slowed Amazon down, as did those 300x and 100x P/E ratios.

To be fair to Saibus, by traditional valuation analysis, it was reasonable to look at triple-digit P/Es and think that AMZN needed to fall back, but the inconvenient fact is that stock valuations are based on crowd perceptions, not spreadsheet formulas. Spreadsheets play a part, but if the crowd wants to bid up a stock, it can, and therein lies the problem with valuation analysis. The crowd doesn’t necessarily care.

In this report, I will dig into how analysts overplay their valuation hand, taking it beyond where it is useful in determining the fair price of a business, to where it is not, in determining the fair price of a stock. From there, they made the mistake of deciding the market itself has an intrinsic valuation to which it must revert. Even vaunted metrics, like the CAPE ratio, diminish long-term performance. Valuation is a pro at dodging bull markets.

It’s time to get smarter than the supposed smarties of stock analysis, and learn a better approach.