By Michael Wursthorn
Shares of companies like Amazon.com Inc., Netflix Inc. and Salesforce.com Inc. have surged this year, driving the stock market higher but also pushing valuations to what some investors consider worrisome levels.
The valuation of the average stock in the S&P 500 is now in the 97th percentile of historical levels, according to Goldman Sachs Group Inc., which analyzed 40 years of market pricing and valuation data. The valuation level is thanks in large part to the rise of highflying tech stocks.
That has kicked off debate among investors as the bull market in stocks is set this week to become the longest in history, based on intraday trading.
Some investors believe the high valuation level shows a lack of breadth in the market's rise, leaving stocks vulnerable to a pullback. An analysis of data going back to 1964 shows that higher multiples have led to weaker returns over 10-year stretches, according to Credit Suisse Group AG.
Other investors counter that the way tech companies operate, with heavy spending on developing new products, along with an ability to disrupt markets or create new ones, makes traditional valuation measures such a price/earnings ratios less relevant. The problem, they say, is that such formulas say more about a company's current situation and profitability than what sales and earnings will look like five years out.
"I don't talk about multiples. That's where the conversation stops," Jonathan Curtis, a portfolio manager at Franklin Templeton's Franklin Equity Group, says of discussions with others about tech companies. "I tell them, 'Help me understand what this business looks like at maturity.'"
He and others argue that investors have to take a longer-term view of high spending that depresses short-term profits, and so leads to elevated price/earnings multiples.
Amazon, for example, has spent heavily to expand its logistics and distribution, as well as its cloud-services arm. That led to slim profits, or losses, in many quarters, leading some investors to question a high multiple for a company constantly diving into new businesses.
Now, the stock, up more than 60% this year, is the single-biggest driving force behind the S&P 500's more than 6% gain in 2018, as its Prime subscription service and web-services arm have created a loyal client base. Amazon's soaring stock price is also due to its ongoing shake-up of the retail, health-care and cloud-computing industries.
Still, Amazon trades at a lofty 85 times future earnings, and over the past three years its multiple has averaged around 115 times, according to FactSet. In comparison, the S&P 500 trades at about 16 times earnings expected over the next 12 months.
Meanwhile, Netflix has spent billions of dollars to acquire content and attract subscribers to make itself the leading streaming service in the U.S.
It trades at a forward price/earnings ratio of 85 times, according to FactSet.
Facebook shows, though, how companies can grow into outside valuations. Less than five years ago, Facebook was trading at more than 50 times forward earnings as it outspent rivals to dominate social media's advertising landscape. Increased profits have brought its valuation down to 23 times TIMES today.
"You have to bring some logic to those numbers to justify these multiples," said Sebastian Werner, lead portfolio manager of Deutsche Bank's DWS Science and Technology Fund.
Mr. Werner's investment team looks for a line of sight on how much extra cash a business will generate after it covers big-ticket expenses, a track record of massive revenue growth year over year and the likelihood of profit-margin growth of as much as 40%.
Perhaps most important is how much many of these companies, especially in the software space, are spending and making on their customers, said Matt Sabel, a portfolio manager for MFS Investments.
Companies like Salesforce spend massive sums to attract customers, stretching its price/earnings ratio above 50 times. But instead of looking at that cost and assuming it is high or low, some investors have taken to measuring it against the value of those customer relationships.
For a company like Salesforce with multiyear customer agreements, the value of its clients vastly outpaces its acquisition costs, bullish analysts said. By determining the ratio of the lifetime value of a customer versus a company's customer acquisition cost, an investor can determine whether spending on marketing and sales is paying off, they add. Shares of Salesforce are up 43% this year.
"It's very easy to analyze this year's costs and say look at all this SPEND and it's unprofitable," said Mr. Sabel. "But the cash-flow stream continues to grow over many years."
Of course, high multiples also mean companies can't afford even small missteps. Netflix shares, for instance, have fallen 16% over the past month after it said in July that it missed its own forecasts by more than a million subscribers in the second quarter.
And some investors caution rising interest rates will force down overly optimistic valuations. The recent period of superlow rates helped support higher valuations since future profits are worth more when discounted back into today's money. As rates rise and debt gets more expensive, profit margins will fall, said John Prichard, president of Knightsbridge Asset Management.
Valuation concerns have already crept into the market, some investors said, as defensive stocks that tend to post lower growth than companies like Amazon and Facebook have outperformed. The top five performing S&P 500 sectors the past three months are all defensive, Bank of America Merrill Lynch said in a recent note, including consume staples, utilities and health care.
"Valuations matter a lot more as you extend the time horizon," said Mr. Prichard. Add interest rates to the mix and "at some point that will depress high-P/E stocks."
Write to Michael Wursthorn at Michael.Wursthorn@wsj.com
(END) Dow Jones Newswires
August 19, 2018 08:14 ET (12:14 GMT)
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