How To Value Any Stock

By datatrekresearch in Blog

Every investor needs a fast and accurate approach to equity valuation, and classic tools like price/earnings ratios are no longer useful. For example, Tesla trades for 200x earnings and GM goes for just 7x. This tells us nothing about whether one or the other is a good investment.

In our latest video, DataTrek co-founder Nick Colas outlines his favorite method for understanding exactly what expectations are embedded in stock prices. Not only does it allow a clean comparison of GM and Tesla, but it also explains exactly why US Big Tech stocks are under pressure and reveals which are the cheapest names today.

Watch it here on our YouTube channel! Please hit like/subscribe and share this video if you find it useful. Sign up on datatrekresearch.com to sign up for a 2-week free trial to our daily investment newsletter!

Transcript

Hi, Nick Colas from DataTrek here and the topic of today's video is how we approach stock valuations. I want to start with an example that's near and dear to my heart because I used to cover the auto industry at Credit Swisse and later for Steve Cohen at the old SAC Capital. And that's looking at the forward price earnings multiples on GM versus Tesla and obviously Tesla has a huge valuation 216x this year's earnings per share estimate where GM trades for 7x.

And at first blush, this is a pretty easy comparison to understand because Tesla is priced on the promise of robotics and autonomous driving and frankly Elon Musk's very long track record of success in disruptive technologies. So fair enough. And GM trades for the automotive on the automotive cycle and profitability. Also fair enough. That's the way it was when I covered the stock back in 1993. And it's still exactly the same case now.

It's just how much money can GM make on its existing products and new products and how bad or good is the economy going to be and how many cars and trucks can they sell. And that's an okay comparison, but you know 216 versus 7 doesn't really tell us a whole lot. It doesn't really give us a productive way to compare different sorts of investments, different sorts of stories. So let's discuss a little bit what I think is a much better approach. A much better approach.

And here's our model for valuing stocks. And I have personally used this for the better part of 25 years. I think it works very very well. And I'll explain why. We break down the value of any company, public, private, whatever, into two components. The first is current value based on what it earns today. And then future value, what it might earn in the future. How much more can it grow? How much more can it improve its competitive advantage?

All sorts of things related to what the company might do down the road. Current value is thankfully very straightforward math. You simply take a near future earnings like 2026's earnings estimates for a public company and divide it by 0.1. That's also known as 10% obviously and that gives you the perpetuity value of its current earnings. So if a company can earn what it earns today forever, it's worth X. Future value is a judgment call.

Now in public markets we have a little bit of a break because companies are valued in the stock market and that valuation implies whatever its future value might be. The difference between current value and the stock price is what the market anticipates is future value. So let's cycle back to that GM versus Tesla comparison and see how it shapes up based on this new kind of math.

Now GM's expected to earn $12.44 a share this year making its current value $124. So basically 12 spot 44 divided by 0.1 is $124. The stock trades for $81. So a discount. Now Tesla is expected to earn just over $2 a share. That makes its current value $21 and its current price is $417. So the bottom line here is GM trades for .7x of its current value where Tesla trades for 20x its current value.

Now, that's a big difference, but a difference we can begin to think about. Why does GM trade at a discount to the perpetrity value of its current earnings? And why does Tesla have such a premium to its current cash flows? And is that premium something that is justified, not justified, is an investable. And there we begin to think about what drives these differences. And the answer is competitive advantage because it actually creates and sustains both elements both current value and future value because both assume in the case of current value that the company can earn what it earns forever and in the case of any positive future value that it can grow its earnings further.

Now in the case of GM the discount it gets I think we can tie back to what you probably have known as Michael Porter's five forces model. He uses it to analyze how much power a company has in its current business model and for GM the story here is not awesome right it does have some power over suppliers because it's a big customer but it has very little power over customers because they have a lot of options in the light vehicle market all around the world.

There's also the possibility of new entrants for example from China substitutes in the case of alternative ways of transportation autonomous driving being a potentially very disruptive one and obviously industry rivalry in the auto industry isn't very intense. You got Chinese companies coming in. Japan came in the 70s. South Korea came in in the 80s and 90s. The European side is facing exactly the same challenge.

So when you layer this all together, you begin to understand why the market doesn't give GM credit for being able to earn that $12 a share as a perpetuity. It's giving it a discount because all across these five forces the company has real challenges and always has. Now Tesla's premium is a whole different thing because that comes around to Clayton Christensen's disruptive innovation framework which we've discussed in prior videos.  

That’s where a new entrant comes into a marketplace with a novel technology to challenge incumbents and create new industries. And we've seen this time and time again. Amazon being the prototypical example coming in by starting to sell books in the 1990s. Then it was CDs and it was DVDs and it became everything. They used the internet to disrupt brick and mortar and retail. In the case of Tesla, it's a disruptor along many different fronts.

Obviously, autonomous driving is the current one, but it also is talking about getting very heavily into robotics, which is an even bigger opportunity because robots can be used in a whole variety of settings, industrial, light, commercial, even residential. So, the promise there is quite large.

And the bottom line here, as we've seen from these two examples, is markets put a real premium on disruption, but a discount on the status quo. So what we saw in that first slide of 20 times earnings versus 0.7 is really about the market's assessment of competitive advantage over time.

Now let's take a step back because I think this is a very powerful tool not just for analyzing two companies but for analyzing say all of US big tech and that's what this slide does. What I've done here is break down the big eight. We include Broadcom and big tech now because its market cap is quite large and broken down the valuations for each of the big eight US tech companies into its future value based on earnings estimates, present value based on current estimates,  future value which is current price minus present value.

And then in the column that I've lightly shaded in gray the percent of the current price that is driven by future value. And here you see a couple of things that I think are really interesting and important.

The first is the average US big tech company ex Tesla trades for 56% future value. Meaning just over half of its current stock price is not supported by present value. It's based on the market expecting more earnings in the future. And so these are relatively expensive companies. Now Tesla really stands out here because it's 95% future value.

Every other name is in the 50s and 60%. So Tesla really stands on its own as a story that is 95% based on what might happen in the future versus the current earnings power of the company. You know fair enough. I mean they have a track record of success so I don't think we begrudge them that but it's a big number. The rest of the names trade at slight premiums or discounts to the average.

So for example, Meta trades at a slight discount, 53% of its value based on future value expectations. Amazon also 53, Microsoft also 53. These names have gotten creamed obviously in the last couple of weeks. And so they're a little bit cheaper than they used to be. But they're still based more on the value of the future than the value of their present earnings. On the flip side, Nvidia and Apple traded a bit of a premium, 58 and 64%.

Now, let's zoom out one more time and look at the S&P as a whole. Because the S&P, based on current earnings estimates for the year, is trading for 54% future value, pretty much like big tech. But when you strip out these big tech names, the S&P trades for just 34% future value. So the majority of the S&P's valuation is based on current earnings with just a bit of a premium, call it mid 30% for future growth, which is fair because you got a lot of very high quality companies in the S&P. So they should be able to grow in the future.

But the S&P ex big tech is much cheaper than big tech. And I think this goes a long way to talking about and explaining why tech's been under pressure because these worries about AI spend really are beginning to ping on valuations for I think very logical reasons and we've talked about them here today. So summing up the the analysis here, what I want you to take away from this talk is that valuation is really about competitive advantage.

And there's three different models to think about. One is when a company has a very limited competitive advantage like GM for example or any auto company they're going to trade for a discount to current value because the market I think in most cases rightly worries about whether or not that company can sustain current earnings. If you've got a point of view that they can that stock is a buy. If you don't think they can then it's maybe better to look elsewhere for investment opportunities.

The second one which I think the S&P 492 call it exemplifies very nicely is some modest competitive advantage. Meaning most of the value of the company or the index in this case is tied to its current earnings. That's a pretty safe place to be in most cases because a company a big public company can usually sustain earnings.

And then you have big tech which really is in a league of its own where the market rightly sees a very strong competitive advantage and therefore gives most of the value of the company to what it might do in the future versus what it's doing in the present.

Now the range that we talked about with these companies is quite wide. Meta's got 53% of its stock tied up in future value. Tesla's 95. So that's a big big spread, right? And you got to decide very carefully if Tesla's worth it or if Meta is too cheap. But that's the right kind of conversation to have.

The last point is one I want to circle back to that we've discussed on the prior slide which is big tech is solidly in bet the ranch mode. That future value that the market is discounting. They are going all in to achieve. That's why the AI investments are so controversial but also so important because without them their future value really begins to become into question.

And if they're not willing to invest in the next big thing, then I think we have to question if their future value is actually fairly set. So the bottom line, I think, in terms of investing now in US large cap stocks is you got to focus on these tech names because there's very little room for error in terms of valuations.

But these companies do have a long track record of success. We at DataTrek do think they have a future. They do have strong future value and they're going to do fine over time. But I hope that this conversation today has given you some sense of why the valuations already imply a lot of future value, a lot of future growth, and why the market's a little bit worried about the capex that they're spending in order to achieve that future growth.

So with that, I hope you found this video useful. If you did, please hit like and subscribe and be sure to check out DataTrek at datatrekresearch.com for a two-week free trial to our work. With that, have a great day. Thanks so much for watching.