Imagine this exchange, which is typical of what we see on the financial news:.
- Wall Street Analyst: “We think the stock is very attractive here. There’s massive demand for semiconductors, and this company has the most advanced products. It trades at 100x this year’s earnings, but we think it has a lot of room to run.”
- Interviewer: “What do you think the company will look like in 5 years?”
- Wall Street Analyst: [Laughs] “Oh, my goodness! I have no idea what it will look like in 5 years!”
Judging by today’s crazy tech stock valuations, few buyers look very far down the road. Instead, they trust the feeling of being part of a crowd and seeing favorable price momentum.
Many investors forget a basic math reality: a price-to-earnings (P/E) ratio of 100 means you are paying $100 for every $1 of current profit. If earnings never grow and all profits are paid out to owners, it will take a century just to break even. In a competitive economy, assuming explosive profit growth to justify that price is a huge gamble.
What is the Business Actually Worth?
A stock can be treated like a lottery ticket – and many people do exactly that. Professional money managers often chase high-flyers just to keep up with short-term benchmarks, even when it risks their clients’ wealth.
But a stock is not a piece of paper; it’s a fractional ownership interest in a real business.
The value of any business comes from the total cash it will produce for its owners over its lifetime, adjusted for the time value of money and the risk that things won’t pan out.
Over time, market prices will reflect business value. Dreamers imagine that stocks can go to the moon, but actual cash flow acts like gravity, eventually pulling overpriced shares back to earth.
Thanks in Advance
We might be critical of those paying silly prices, but we should also thank them. When they dump boring, high quality businesses to chase the latest trend, they create the exact opportunities we are looking for.
Barry Dunaway, CFA®
Director of Research
America First Investment Advisors, LLC
Omaha, Nebraska
This post expresses the views of the author as of the date of publication. America First Investment Advisors has no obligation to update the information in it. Be aware that past performance is no indication of future performance, and that wherever there is the potential for profit there is also the possibility of loss.