Tag Archives: FAANG stocks

Are Tech Stocks Cheap?

Are technology stocks cheap? It seems like a strange question to ask as the market drops on news that Apple has indicated weaker future sales. I also doubted whether Facebook’s price reflected its business value in the middle of this past summer. I thought fair value for the business was around $140 per share assuming it could grow its free cash flow by a robust 6% annually over the next decade. The stock is now in the $130 range after pushing higher than $200 in the early summer.

But technology isn’t just the FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google). And at least two important firms – DoubleLine and GMO – think the sector is at least relatively cheap. Here’s why.

First, technology is trading cheaply on a Shiller PE basis, shown by the fact that the DoubleLine Shiller Enhanced CAPE Fund (DSEEX) holds the sector. By using a bond portfolio as collateral, this fund gains exposure to an equity derivative that delivers exposure to four of the five cheapest S&P sectors (tossing the one with the worst one-year price momentum) on the basis of their Shiller PE ratios — and technology is one of those sectors currently. The Shiller PE, as a reminder, is the current price of a stock, sector, or index relative to its past decade’s worth of real, average earnings. Right now (and for more than a year) technology has come up as one of the four sectors the fund owns, meaning its Shiller PE is lower relative to its own historical average than other sectors’ Shiller PEs are to theirs. The other sectors the fund owns currently are Healthcare, Consumer Staples, and Communication Services.

This mechanical application of the Shiller PE may not satisfy investors looking for more a more absolute definition of value, but, relative to other sectors, technology is cheap on a serious valuation metric. If you’re going to be allocated to U.S. stocks in some way, shape, or form, this is a reasonable way to achieve that allocation.

Second, GMO, which is also a fan of the Shiller PE metric, and uses it in its asset class valuation work, also likes technology stocks. The Boston-based firm just published a white paper, written by Tom Hancock, the head of the firm’s Focused Equity Team, arguing that technology stocks were attractive. The firm’s “Quality” strategy has 45% of its assets in technology stocks, “including positions in three of the five FAANG stocks.” Alphabet (Google) and Apple are the two largest holdings of the firm’s Quality mutual fund (GQETX), managed by Hancock.

Rather than relying on traditional valuation metrics when picking individual stocks, the firm looks at how Alphabet, for example, invests in R&D, and how that investment can translate into higher future revenues. In other words, R&D isn’t properly counted as an expense that will never yield future revenue and earnings growth. On the basis of accounting adjustments like this, GMO views Alphabet as a cheap stock.

Hancock notes that GMO’s Quality portfolio doesn’t trade at traditional valuation multiples that are different from the broader market. But, “in an expensive market, quality companies typically trade at higher P/E’s than most ‘value’ investors would like.” Higher multiples are justified for companies with resilient margins and strong business models, and Hancock thinks the strategy can produce returns of 5% in excess of inflation.

Quality companies in the U.S. are also cheaper than those outside of the U.S., and Hancock surmises that’s because of a kind of scarcity value. Companies with consistently high margins and returns on invested capital are less prevalent outside of the U.S., so they trade at dearer prices.

Moreover, the U.S. technology sector consists of a diverse group of stocks. Only one of the FAANGs – Apple – is in the top-10 of the S&P 500 Information Technology Sector. Some of the largest constituents of that sector are the darlings from the technology bubble of nearly 20 years ago – Microsoft, Intel, Cisco, and Oracle. They turned out to be good businesses that were just overpriced then. Hancock lists Microsoft’s virtues as being in the cloud growth business and having a lock on the consumer. Qualcomm, by contrast, has a unique position in the smartphone supply chain, while Oracle provides legacy software and benefits from high switching costs. Finally, Visa and Mastercard are “borderline tech” companies, but, nevertheless, find themselves near the top of the S&P 500 Information Technology sector.

So, despite being known for top-down asset class valuation calls, the GMO Quality strategy is bottom-up and fundamentally oriented. And, just like the more mechanical, single-factor approach of the DoubleLine fund, it also finds technology stocks cheap – or cheaper than their brethren in other sectors.

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Both the DoubleLine Shiller Enhanced CAPE fund and the GMO Quality III fund are worthy of investors’ consideration. Beware that the latter is for institutional investors, given its $10 million minimum. Get in touch with us if you have questions about portfolio construction, asset management, or financial planning.

Facebook Follow-up: Looking At Two Other Tech Darlings

Well, that was fast.

I published an article on Monday wondering about Facebook’s valuation, and on Thursday Facebook dropped around 20% in the wake of its Q2 earnings report, putting in the worst day for a stock in market history on value lost (nearly $120 billion) basis. The report showed robust 42% revenue growth, but that number was below expectations, and, more importantly, the online social media firm warned about future revenue weakness. Facebook will have to hire more personnel to police the “bots” posting on its site, and that will cut into the firm’s prodigious margins.

In my article, I “reverse engineered” a discounted cash flow model to show that the market was assuming 6% free cash flow growth and more than 12% revenue growth for the next decade. Today’s market price for Facebook assumes a 4% FCF growth rate – a 33% reduction from yesterday’s price.

So how do other tech giants look these days? Are they all poised to tumble like Facebook? Some are and some aren’t.

Alphabet

Alphabet is often compared to Facebook. Both companies are in the online advertising business along with the ancillary business of finding out as much information about, and invading the private lives of, consumers as much as possible.

It turns out, the market is making almost the same set of assumptions it was about Facebook before its drop. The free cash flow growth rate that allows a model to arrive at today’s current stock price as the fair value for the business is 6.5% — just a bit over the 6% rate that Facebook’s stock price assumed before it’s crash.

As I said in my previous article, I haven’t studied the online advertising market, so I don’t have an opinion on whether Alphabet can grow this much. Alphabet turns a little more than 20% of its revenue into free cash flow. That makes it around half as efficient in this regard as Facebook, though Facebook’s ratio may well shrink in the future based on its need to pay more people to police its platform.

Alphabet is involved in more diverse array of business than Facebook is. Its Android operating system is in many of the world’s mobile phones. Its Internet browser, Chrome, is popular, and its subsidiary Waymo, is involved in the development of self-driving cars, though Facebook has also made efforts at driverless cars.

Growth isn’t easy to predict for companies like Facebook and Google, and the similarities implied by doing these reverse discounted cash flow models may indicate that analysts and investors, up until Thursday, had picked nearly the same growth number for both companies out of convenience.

None of this means Google is the next technology stock to tumble though. Future quarters may disappoint investors the way Facebook’s recent quarter did, but they may just as well impress the market. Everyone now will have to persuade themselves whether the optimism baked into Alphabet’s price is justified. For at least the two days of trading this week after Facebook’s stumble, it seems they have.

Tesla

Speaking of driverless cars, Steve Eisman, a manager profiled in Michael Lewis’s The Big Short, thinks another popular technology company, Tesla, isn’t doing enough to make inroads in that area. Indeed, the electric car maker has burned through more than $8 billion in cash over the last four years, $4 billion last year alone. It shows no signs of being able to generate positive cash flow.

Its current market capitalization of around $50 billion assumes one scenario (shown below) whereby it somehow produces $1.7 billion in free cash flow next year and grows that number by 5% annually for the next decade. This would be nothing short of miraculous for a company that has lost so much cash already. Perhaps it’s unwise to count Elon Musk out, but investors should think hard before sinking money into an enterprise that hasn’t been able to generate free cash flow for so long. Second thoughts are especially in order for those contemplating buying shares given Tesla’s nearly $10 billion debt load and the nearly $0.50 billion interest payments it made last year.

Conclusion

It’s hard to know if Facebook’s (and now Twitter’s) problems represent the technology sector’s comeuppance. Facebook produced more than $17 billion of free cash flow last year, and it’s still a healthy company even if investors are re-thinking past assumptions about its growth and profitability. Not all of today’s technology firms have as unlikely a road to success and to posting the profits that justify their stock prices as Tesla.

Is Facebook Worth Its Current Price?

All assets are worth the present value of their future cash flows. Even if you haven’t been to business school and heard this financial theory, you probably have some intuitive sense that if you buy a piece of real estate as an investment, you know that the income that property produces relative to the price you’re paying for it is important.

The problem with a “discounted cash flow” approach (forecasting future cash flows and applying a discount rate to them to arrive at a present value) is that people rarely know what future cash flows will be, and nobody knows how to discount them properly to arrive at a present value. Regarding discounting, Warren Buffett likes to apply the rate on the 30-year U.S. Treasury. Others like to apply a discount rate as a “hurdle rate” that reflects the return they’d like the investment to deliver – say, 10%. As Buffett’s sidekick, Charlie Munger, says, valuing an asset isn’t supposed to be easy. And that makes sense since skill at valuation is lucrative.

But instead of estimating cash flows and applying a discount rate to see what an asset is worth, sometimes it can be useful to understand what future cash flows the market is anticipating by awarding a stock its current price. When you back into, or reverse engineer, the future cash flow assumptions the market is making, you can sometimes decide if Mr. Market is off his meds or not.

(Discounting a cash flow is the opposite of compounding it the way you might do a compounded interest calculation. It involves dividing the cash flow by your chosen interest rate for each year in the future the cash flow occurs. So an assumed $100 payment next year discounted at 10% is worth around $91 today. An assumed $100 payment in five years is worth $62 today, or $100/(1.1^5).)

So what future cash flows is the current ~$600 billion market capitalization of Facebook anticipating, and are those future cash flows achievable? Let’s try to find out.

From 2013 through 2017, Facebook’s revenue has grown remarkably from under $8 billion to more than $40 billion. Also, free cash flow, as Morningstar calculates it has gone from under $3 billion to nearly $17.5 billion over the same time. That’s around a 55% compounded annualized growth rate.

It turns out that if Facebook can grow its free cash flow by 6% annually for the next decade, and then we assume its return on invested capital equals its cost of capital after that (meaning it loses it competitive advantage), we arrive at a present value roughly equal to its current $600 billion market capitalization, using a 10% discount rate.

Facebook has converted $0.40 of every $1.00 in revenue into free cash flow over the past few years. Assuming that prodigious profitability continues, Facebook would have to increase its revenues by more than 12% annually for the next decade to justify the current stock price. Its 5-year revenue growth rate, according to Morningstar is 20%. A drop-off is inevitable, but it’s difficult to know how much of a drop-off to expect. How mature is Facebook? That’s a big question for an analyst.

To put that revenue growth in perspective, compounding its current $40 billion revenue by 12% annually (not quite enough to get to 6% FCF growth at the current 40% conversion rate of revenue to FCF) would result in more than $120 billion in revenue in 2027. That’s more than Google’s $110 billion in revenue and a little more than half of Apple’s $229 billion in revenue. Can Facebook achieve that revenue growth? That’s another tough question for an analyst.

Facebook’s business model is an advertising one, and I haven’t said anything about the online advertising market. An analyst would have to know how big it is, how much of it Google owns, or whether Facebooks can, or needs to, capture some of Google’s share to justify its current price. At first blush though, growing revenue by 12% or more for the next decade seems like a tall order. Since I don’t know the online advertising market, I can’t say it’s impossible though. Also, one needs to make a judgment about whether Facebook will suffer from competition. Will another platform make inroads into Facebook’s business, or does it benefit from a kind of network effect whereby enough people are already on Facebook that others have to join to be involved in social media?

But this is the type of analysis you have to do if you’re going to invest in a stock – and it’s not even the bare minimum since I haven’t looked at the online advertising market. Buying shares of Facebook because your friends and neighbors own it or because you just think “it’s going up” isn’t really an investment rationale.

We could have done a sensitivity analysis, adjusting discount rates and the growth trajectory instead of just assuming an even 6% free cash flow growth every year. We also could have adjusted margins in the future — will the same amount of revenue become free cash flow in the future? Still, this simple step gives us some idea of what the market is forecasting for Facebook. I wouldn’t short Facebook, but you have to be optimistic to invest at this price.