Skarbeck: Firms with high ratios could take a tumble

October 19, 2013

Ken SkarbeckOn occasion, it is interesting to study the stocks of businesses that are outliers on the bell curve of business valuation. For a value investor, that means looking at stocks selling at huge multiples above traditional valuation yardsticks. These can be found in stocks with high price-to-sales ratios and high price-to-earnings ratios.

A fairly impressive list of large companies has PS ratios between 10 and 40. First, let us ponder that statistic: A PS ratio of, say, 25 times implies it would take 25 years at the current sales level just to recoup your investment in revenue, let alone profits.

Ah, but that reasoning—although eye-opening—has one giant flaw. Companies with high PS ratios are usually experiencing rapid growth. If revenue is expected to climb 50 percent next year, a company with a 25 today implies a “forward” PS ratio of 17 next year, 11 in year two, and so on.

Often, high PS ratios indicate businesses that have very high profit margins—revenue minus all costs. Two companies that stick out in this category are Visa and Mastercard, with PS ratios of 17 and 11, respectively, and profit margins that approach 40 percent. These firms have minimal competition to chisel away at those gaudy profit margins, and thus the stock market awards them high valuations. Warren Buffett would say both companies have a “moat” around their business.

More problematic for investors are highly valued companies that are barely profitable or losing lots of money. In this category we find the social media businesses that have seen a spate of IPOs in recent years: Facebook (20 PS and a 225 PE), LinkedIn (21 PS and 900 PE), Yelp (25 PS and unprofitable), Zillow (21 PS and unprofitable) and soon to be joined by Twitter (30 PS and unprofitable).

These companies are growing fast, but require a leap of faith. With so much of the future value already implied in the current stock price, any unforeseen surprises can prove devastating to holders of these stocks. Consider that Facebook’s $123 billion market value exceeds Intel’s $117 billion, while LinkedIn, at $27 billion, has a higher valuation than Marathon Oil, $25 billion.

Market values are in the stratosphere for companies that operate in the “cloud” or with “big data,” such as Workday, Netsuite, Salesforce, Splunk and the aptly named Rocket Fuel. Tesla, the electric sports car maker, confounds investors with a PS of 17, no earnings and a $22 billion market value.

In contrast, older Internet companies actually look mature in their valuations compared with the new crop: Google ($300 billion market value, 5 PS, 25 PE), eBay ($70 billion, 4.5 PS, 25 PE) Yahoo ($34 billion,7 PS, 20 PE).

Then there is quirky Amazon. The online retailing giant has a PS of only 2, but has hardly ever made money despite its $140 billion market value. As Amazon seeks to dominate all that is retail, investors seem content as management plows back cash flow into its infrastructure.

In studying these highly valued companies, one has to wonder if much of their future value is already priced into their shares. Any stumble in their hyper growth could prove disastrous for their shareholders. They lack what the great investor Ben Graham described as a “margin of safety.”•


Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money-management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.


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