A lot of novice investors make the mistake of investing in a company that they love while ignoring just how over-valued that stock is. Just like products in a store, stocks can be wildly overvalued or listed at an insanely attractive sale price. There are traps in both categories. Sometimes there are seemingly low priced stocks that are priced so low for a very good reason and should be avoided instead of bought thinking it’s a sale. Other times, there are high priced stocks that value investors ignore, but it turns out that the underlying fundamentals of that company are even better than the high stock price would suggest. This post is about how to approach highly valued stocks.
First of all, I want to make it clear that in most situations, the actual stock price is irrelevant. Companies can use stock splits and reverse splits to keep the stock price in just about any range they want. When I mean “highly-valued stock”, I’m talking about a company that has a fairly high P/E compared to the average company out there. A stock with a high P/E value is a highly valued stock, among other metrics (like perhaps a low dividend yield AND a high payout ratio, or a high book value).
Why are some stocks so highly valued? It can be for a variety of reasons. A common reason is that the stock has high growth potential. Another reason is that it might have an excellent competitive advantage (a powerful brand, for example). A company with low debt will typically also be more highly valued than an otherwise equal company with a lot of debt. These “premium” companies are often worth paying up for, but only to a certain extent.
So how do we deal with highly-valued stocks? Let’s use an example: VISA (V). I’ll start off with a mini-analysis of the company.
Visa Inc. went public in 2008, and it was the largest initial public offering in US history. Visa’s share price has appreciated up to $92 per share in this past year.
In 2006, Visa had $2.67 billion in revenue. In 2009, Visa had $6.29 billion in revenue. That’s an extremely impressive 33% annual growth over 3 years.
In 2006, Visa had $455 million in earnings. In 2009, Visa had $2,353 million in earnings. The earnings are rather erratic, however, making a short-term annual earnings growth number somewhat irrelevant. Long-term earnings growth might also be unhelpful information since the company has so recently gone public and that can cause a significant shift in growth.
Visa has a pristine balance sheet. They have virtually no long-term debt.
Visa pays a small dividend. The current yield is about 0.54%, and the most recent (and only) increase since the IPO was a 19% increase. It’s likely that they’ll continue growing their dividend.
Visa has spent a lot of cash on share buybacks. One of the first things they did after going public was to authorize an over $10 billion share buyback to repurchase many of their shares that were held by large banks. After that, $2.6 billion in shares were repurchased in 2009, and another $1 billion is authorized for 2010.
Visa operates in over 200 countries. Few companies in the world have that kind of exposure. They’ve chosen the absolute best international marketing channels possible: The Olympics and FIFA, among others. There are more Visa cards in existence than any other brand.
Transactions with Visa cards increased 8% in 2009 over 2008, even though total purchase amounts decreased. This shows a shift towards electronic payment even as people spend less. In addition, some places ONLY accept credit/debit cards, like certain on-board airline purchases.
Visa is not a financial corporation. They merely provide the brand and the processing for electronic payments. Credit balances are held by their network of partnering banks, meaning that Visa carries no credit risk. In fact, Visa processes a larger volume of debit transactions than credit translations in the US.
Visa has among the most definitive competitive advantages possible. Firstly, they have one of the strongest, most globally spread brand names around. Secondly, their business is one that has high switching costs. A high switching cost means its difficult or costly to change brands. For example, it would be easy for someone to switch from Coke to Pepsi (all you have to do is buy the different product next time you go to the store), but difficult for the person to switch from cable tv to satellite tv (you have to switch the box, deal with getting things installed, close accounts that might have certain time contracts, and so forth). Banks that use Visa would incur significant difficulties in switching card brands, much like how a person incurs difficulty when switching tv services. High switching costs are a big competitive advantage. Thirdly, Visa has economies of scale as the largest brand name of credit cards with VisaNet, their huge processing system.
What’s the difference between Visa, Mastercard, Discover, and American Express?
-Visa and Mastercard are quite similar. Both of them are just electronic payment processors with brand names. They do not issue cards themselves, and so neither carries any credit risk. Instead, they both partner with banks that offer the cards.
-Discover and American Express are different. Compared to Visa and Mastercard, they are accepted in far fewer locations (mostly because they charge the merchant a higher fee). Both Discover and American Express issue their own cards, so they have credit risk, though in recent times both of them partner with banks in addition to issuing their own cards. American Express wasn’t originally a credit card company- their cards had to be paid in full each month, but credit cards are now among their list of products. Discover and American Express typically offer more rewards, along with higher costs.
Visa’s sum EPS for the last four quarters is $3.10. Based on the current stock price, Visa has a P/E of about 30 and a price to book ratio of about 3.3. This is certainly a highly valued company. Let’s see how Visa stacks up to other well-known high-fliers: Google has a P/E of about 28 and a P/B of about 5, Apple has a P/E of about 23 and a P/B of about 6, Netflix has a P/E of about 38 and a P/B of about 20, and Amazon has a monstrous P/E of about 65 and a P/B of about 11. All of them have pristine balance sheets with virtually no debt except for Netflix which does have a moderate amount of debt.
What about consistency? Visa has the most erratic quarterly earnings out of the bunch, with some hugely profitable quarters and some big loss quarters. The others all have pretty consistently growing earnings, with Apple and Amazon having typical seasonal patterns (huge fourth quarter), while Netflix and Google are less seasonal.
A good tool for determining whether a growth company is overvalued or not is the PEG ratio, popularized by Peter Lynch. The PEG ratio is the P/E divided by annual EPS growth. According to Lynch, a fairly valued stock has a PEG of about 1.
The PEG does have some flaws. The main flaw is that it doesn’t work for low or average valued companies. For example, if I have a company with a P/E of 10 that has a 4% growth rate and pays a 5% dividend and has little debt, then the PEG is 2.5 (10/4) even though by these metrics, the company is attractively valued. For high growth companies, the PEG is a better approximation. It’s possible to fix this somewhat by adding the dividend yield to the growth rate of the calculation (so in the above example, the PEG ratio would be 1.11). In addition, the PEG doesn’t take into account debt. All of the sample companies presented have no debt with the exception of Netflix, so this should not be a problem when it comes to consistency.
Let’s apply the PEG ratio to the list of companies. For Growth Rate, I’ll use the two-year average forward growth rate estimated by analysts instead of trailing growth rate, since the last few years have been chaotic and unusual, and therefore possibly unhelpful. This means that the calculations are highly uncertain and should only be taken as VERY broad assumptions. For Visa, I’ll add the small dividend yield to the estimated growth rate.
Visa PEG: 30/(21+0.54) = 1.39
Google PEG: 28/15 = 1.866
Apple PEG: 23/47 = 0.49
Netflix PEG: 38/25 = 1.52
Amazon PEG: 64/37 = 1.73
Based on PEG ratios, and assuming analysts are at least in the ballpark with their estimates (which they very well might not be, and in fact likely are not), Apple is by far the best value out of the bunch with Visa coming in at distant second. Interestingly, Apple has the highest projected growth yet the lowest valuation.
Another thing to consider is the probability of the success of these companies. This is rather qualitative in nature. In other words, what risks are there? Apple, for example, is dependent on the success of high technology products and maintaining their high profit margins, so there is considerable risk there and that might be one reason why it’s valued rather lowly (at least relative to the others). Netflix has the most risk out of the bunch in my opinion, and combined with their moderate debt levels, is the least attractive investment to me. This doesn’t mean it won’t shoot up in price, but as an investor and not a speculator, it does not interest me. Visa has rather erratic earnings and is new on the public scene, but has a long-established business and has the most global exposure. They do face regulatory risks, though. Google has the least growth and the least diverse revenue stream, but the most consistent earnings reports out of the bunch and is a very flexible company. Amazon has a very straightforward online retailer business with no significant threats in sight, but their Kindle business faces new strong competition from the iPad and the Nook.
All in all, I’m neutral on Visa and Apple, and not interested in owning any of the others.
So what’s next? You’ve valued the companies (and hopefully you’ve done more thorough research than this- this is just a preliminary assessment. Cash flow should be considered, as well as various other metrics and qualitative info), so what do you do next? Well it depends on whether you own the stock already or not. Sometimes we want to buy great companies but we aren’t sure whether they are really worth their lofty valuations, while other times we’ve purchased a company only to see it become far more highly valued and we’re wondering whether we should continue holding onto the stock or not. I’ll cover both scenarios below for Visa.
Looking to Buy?
It is my opinion that if you invest in companies with lofty valuations, you better have an extremely thorough understanding of the company. Of course, you should deeply understand any company you invest in, but as valuations become higher and higher, you have to be more and more sure that you are right, since one little slip up could prove your whole investing thesis incorrect.
It doesn’t hurt to allocate a part of your portfolio to highly-valued stocks as long as you really understand those companies and are comfortable with them for the long term.
There are three ways to do this:
-You can buy shares of the company at the current price, realizing that although you’d like to purchase at a slightly lower price, the long-term value of this company should boost shares in the long-run. Or maybe you already think the price is attractive, even at these levels, and you buy.
-You can wait and watch the stock to see if an opportunity presents itself to purchase shares at a lower price. The advantage is that if the stock price drops, you get your chance, but if the stock price never drops to the level you’re waiting for, you’ve missed out.
-The third option is that you can sell cash-secured puts on the stock. This mixes the the pros and cons of both of the above methods. Selling a cash-secured put means that you are giving someone else the right to sell you shares of a company at an agreed upon price, and in exchange, they are paying you for this agreement. This only works in bundles of 100 shares.
For example, you can sell an option that obligates you to buy shares of Visa in September 2010 for $85 per share if they drop to or below $85 per share at that time. Under this scenario, you’d need to keep $85 per share available (cash-secured), and you’d be paid the current premium of $2.96 per share for taking on this obligation. This gives you a return of 2.96/85 = 3.5% in five months if the share price stays above $85. (Then if you want you can repeat, earning a solid annual rate of return.) If the share price drops below $85, your cost basis is 85 – 2.96 = $82.04, and you purchase the stock.
Alternatively, you can sell September 2010 puts with a strike price of $90 instead, but the premium is a higher $4.95. This gives you a five-month rate of return of 5.3% if the shares stay above $90, and cost basis of $85.05 if the shares drop below $90 and you end up purchasing.
This tactic allows you to sit around and wait for a better price, but the risk is that if the stock price drops far below the strike price, you’ll lose some money on the original purchase. This risk, however, is present if you were to buy the shares outright from the beginning.
As long as you are a long-term investor and not a speculator, you should only sell puts when you are indeed ready to buy the shares should they fall below the strike price (a speculator doesn’t actually want the shares, just the premium, usually), and you should always be cash-secured instead of naked.
Sometimes we find a great value and over time, the price of our investment skyrockets, and we’re left wondering whether our investment is overvalued and worth selling now. (This is an enviable problem to have.) If, for example, you own Visa, and it’s price has increased considerably, you may be wondering whether you should hold onto what you have or sell some or all of it to realize profits and invest elsewhere.
The first thing to consider is the cost to sell. If you find another investment that you believe is slightly better than the stock you’re invested in, it might not be better after all the costs of selling are considered, especially capital gains tax. When I consider selling a stock that has become highly valued beyond what I believe it to be worth, I take into account that after I sell it, I have to pay capital gains tax, and I also give myself an extra margin for the extra work and effort I have to put in. So I don’t sell an overvalued stock unless I have a quite strong desire to do so.
Much like the previous example, there are three ways to approach this.
-You can continue holding onto your stock, believing that although it is highly valued, it is still a reasonable investment and is not worth paying capital gains tax at the moment.
-You can sell it at the current stock price because you feel it is overvalued or that you have significantly better opportunities elsewhere.
-You can sell a covered-call on your position, mixing the pros and cons of the above two methods.
Selling a covered call means you own the stock and you are selling someone the right to buy it from you at a certain strike price. For example, if you own enough shares of Visa, you can sell a September 10 call with a strike price of $100 for $3.20 per share. This means that you’ll be paid $3.20 per share, but if the stock price rises above $100 before the call expires, you’ll likely be required to sell your shares. If this doesn’t happen, you’ll receive a rate of return of 3.2/92 = about 3.5% for five months (plus whatever the stock price does during that time, up or down). If, for example, the share price soars to $105, you’ll be forced to sell at only $100, but you’ll have received the premium as well. You can also sell calls at a higher strike price for a smaller premium. Or you can pick a different time frame (other than September).
Basically this tactic gives your stock a high dividend yield (with cash coming from premiums instead of dividends), but you’re obligated to sell if the stock price gets high enough. As long as you are an investor and not a speculator, call options should only be sold if you are truly ready to sell the shares should the stock price reach the agreed upon level, and of course you should own the shares in the first place (covered call, not naked call). And if you’re a long-term investor, like I hope most of my readers are, you should only sell calls after you’ve already owned the stock for quite a long time and you believe it is rather overvalued.