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ARE WE IN THE MIDST OF A BUBBLE?

Nishlen Govender
Portfolio Manager

 
TECHNOLOGY COMPANY VALUATIONS AND THE WORTH OF COMPANIES

As an equity portfolio manager, I am getting asked one question a lot of late: “Are we in the midst of another tech bubble?”. In the face of the COVID-19 crisis, with equity markets finding all-time highs, it’s a good question. Surely such highs can’t be the case? To answer that question, you need to understand what something is worth. The answer, however, is not simple. How do you know how much anything is worth?

When I say anything I mean anything: how much should a loaf of bread cost? A car? What about an iPad Pro? The price of something should be based on how much use or value you derive from it. For example, an iPhone could cost US$1,000 and be valuable to me, while someone else may scoff at a price of US$300. Instead of getting into a philosophical debate, let’s focus on a value that we all have considered at some point in our adult lives – the price of a property. When we value a property we consider its location, the size, features like a pool and security, among a long list. The value is relative to the person and their needs. But how much is too much?

Let’s consider an idyllic suburb to illustrate worth. Say I offered you a house in the Hamptons just outside New York. If you had the money, and I offered you a house in the Hamptons for US$100 billion would you buy it? For most, the answer would be no. Homes in the Hamptons are grand and desirable but there are few worth more than US$100 million dollars, let alone US$100 billion. But what if I sold you that property for just US$100? You would jump at the chance!

This leads us to believe the value of a Hamptons property to be somewhere between US$100 and US$100 billion. That spectrum is truly wide, but at the very least, we have managed to create a spectrum. We’ve done this by looking at properties in the area to ascertain value. This is called a relative valuation.

Determining the value of something is crucial when considering what to pay for it, which is clear from the example outlined above. So, what is the fair value of one share in tech giants like Apple or Microsoft, Tesla or in American home improvement retailer, Home Depot? If I believe that a stock is in a bubble – and thus vastly overvalued – then what drove me to that conclusion? In our Hampton’s example, US$100 billion was clearly too much. If a home traded for that price, it would clearly be in a bubble and the price would need to fall.

Yet how do you determine the value for one share of Apple stock? You could do a relative valuation like we did for a Hamptons home. However, it is more difficult as you can’t group companies by location and general standards like you can with houses. Could you find a group of companies like Apple? You could try but you’re unlikely to succeed. Even Apple’s closest competitor in mobile phones, Samsung, is a vastly different company – if you consider the fact that it sells everything from fridges to televisions – which makes it an unfair comparison. The same is true of the likes of Amazon which offers both retail and cloud computing or Facebook which is a combination of very different social media platforms.

Therefore, to understand the value of a company, our industry often uses a process called the discounted cash flow analysis. The four words next to each other may not make sense, but the theory is that a company has future value. If we understand that future value today, then we can understand how much it is worth. If we again use the property example, we can ask how much a property is worth based on the fact that we can earn a rental from it in the future. The price you are paying should be juxtaposed against that future rental income. This is how you generate a list of questions to answer on the value of a property: if the property is well located, in a safe area, with access to amenities and public transport then it could be easy and profitable to rent it out in the future. Buyers would then be willing to pay more for that property based on future rental, which could also be thought of as future profits, and therefore as future cash flow. So, the value of your property is not just what you could sell it for today, it’s also the stream of rentals that you would be giving up by selling that property.

You can think of a company like Apple in a similar way. Apple is not just worth its current stock of inventory, properties and equipment – its worth is based on the company’s ability to produce products and services that will be consumed in the future. The understanding and valuing of that stream of cash flows into the future allows us to determine the value of Apple and other stocks. It is crucial to understand that views will be very different here, unlike our property example.

If I own a flat or house, I should have a good sense of how much I’ll make in rent, based on the rent that people pay in the area around my property. But what will that property or suburb look like in 40 years? That is difficult to say, which is why it’s difficult to predict future profit and cash flows. Similarly, what will Apple look like in 10 years? Will the iPhone still be popular? Will they have found a different growth lever to pull?

If we consider a stock like Microsoft or Netflix, we can ask ourselves similar questions. Will Windows and the Netflix streaming service reign supreme in the next 10, 20 or 30 years? Each analyst and portfolio manager will have their own view and thus determine their own value of a stock. The market is a combination of buyers and sellers. Combined buys and sells from all market participants provide the market price of a stock. How does a share become a “bubble” stock? There have to be enough buyers willing to pay more for the stock than the current market price, which increases the price over time. This also means that their view of a stock’s fair value is higher than the current market price.

VALUING STOCKS

This discussion brings us to the initial question: is the equity market or a specific subset of stocks, such as technology stocks, overpriced or in a bubble? We now have a framework for answering that question for any given stock. To test our framework let’s consider the FAANGM companies (Facebook, Amazon, Apple, Netflix, Google and Microsoft). These companies have all performed exceptionally well over the last 10 years and in the current COVID-19 crisis, where they’ve handily outperformed their peers. This harks back to a time when tech companies outperformed competitors significantly – and then didn’t – in early 2000 during the dot-com bubble.

So, are these technology companies in a bubble? We can use our discounted cash flow analysis to determine this. To do a discounted cash flow analysis, you have to consider and forecast a variety of factors related to a company’s prospects.

However, there are four key levers that determine the significant part of a company’s value:

1Sales or revenue, which is how the company makes money;

2Margins or how much profit a company makes from US$1 of revenue;

3Reinvestment, which is how much the company needs to invest in capital to fund the assets needed to generate revenue. These are assets such as equipment or inventory that help run the business; and

4The cost of capital – the return that you, as an investor, require from this business.

While these may seem like vague accounting concepts, they are the most important questions when valuing a company. Consider revenue, which speaks to how a company makes money.

This raises questions like:

  • Will Nike shoes continue to be popular?
  • Will the world continue to eat McDonald’s in the future?
  • What will the go-to smartphone be in the future?

This leads to a subset of questions like:

  • Does the company have brand value, and thus sticky customers?
  • Do they have the ability to charge higher prices and maintain customers?
  • Is there new competition on the horizon?

The margin discussion brings you back to how the company makes its product, and thus, how it makes a profit after it sells that product. Each company will have a different story. Take Google for example. The company is largely a provider of services such as search, YouTube, Gmail, Android and a host of other software-related products. Creating software requires software developers and engineers, a place for them to work and the servers required to host the product. Google itself doesn’t need much in the way of advertising so, overall, costs are quite low, making margins quite high. This is a positive for software business and the market knows that. We are often on the hunt for high-margin businesses in any given industry. For the likes of Apple, 3M or Tesla, input costs are more tangible as they have factories, equipment and inventory to purchase.

Reinvestment can be thought of in a similar way: if I want to produce, and then generate revenue, what assets do I need? Tesla would need an investment in a manufacturing facility and all the associated equipment. As that equipment gets old it would need to be replaced. Tesla also needs inventory in the form of metal, batteries and tyres to make one car for production – a significant, constant capital investment. This may seem like a vast negative but consider the fact that this lessens the potential for competitors for Tesla.

Start-up car companies are not common given the amount of capital required. This is known as a barrier to entry. We want to find companies and industries with high barriers to entry but with suitable margins and ability to grow revenue. Again, like with margins, there are a host of companies with limited reinvestment needs. These companies are attractive but there can be stiff competition. Take online ride hailing companies like Uber. Given limited startup costs, many apps like Uber have launched around the world fairly quickly, impeding their growth through increased competition.

Finally, the cost of capital. While there are ways to calculate this, it is personal to different investors. What return do you require from an investment? Investors generally link this to a particular interest rate they could receive at a bank. Say your local bank is willing to give you a 5% return, per annum, for a basic savings vehicle. That’s a good place to start when deciding on what return you would require from an equity investment. However, you take on significantly more risk investing in equities so you should demand a higher return. Generally, a number like 6% above the risk-free rate – the rate you received at a bank – is healthy but if your risk tolerance is higher, then you should demand more.

TO BUY OR NOT TO BUY?

Based on how the valuation calculation is done, the higher your required return, the lower the share price you’d be willing to pay. In the current global environment, the yield available on general bank savings as well as on investments in safe government bonds have been slashed as central banks lowered interest rates to support their economies in a difficult environment. The result is the TINA (there is no alternative). This is used to describe an investment in equities as market participants argue that it makes no sense investing in anything other than equities, while interest rates are so low. Given my explanation above, if the bank rate lowers, my required return lowers and I’d be willing to pay more for an investment in a company. That partly explains the rise in the price of stocks – especially in technology companies.

But what about the other aspects of our valuation framework as it relates to technology companies? Let’s again consider FAANGM in the context of this COVID-19 environment. While a host of businesses have underperformed, these companies have held their ground and done better. This is due to the virus itself. We’ve had to isolate ourselves and live and work from home. This has been great for the likes of Facebook as we’ve stayed in touch via Instagram, Facebook and WhatsApp. We have spent more money shopping online which has been excellent for Amazon. Being at home means more time to binge-watch television which has been good for Netflix and Google, via YouTube. We’ve also had to work remotely which has been excellent for Microsoft as we’ve needed more Windows licenses than ever before.

While many companies have been battling the COVID-19 wave, these tech giants have been thriving. All of this relates to the revenue part of our valuation framework: these companies have become entrenched in our lives and are here to stay for the long term. This means that the monthly subscriptions to Amazon Prime, Netflix, Office 365, and similar services are here to stay. We have started, and will continue, to communicate digitally which will be a boon for Facebook, Google and Apple as well as the likes of Microsoft via Teams. If we look at the other aspects of valuation, these companies feature healthy margins, generally low reinvestment costs and they have created high barriers to entry through significant innovation.

What’s crucial is that these companies are nothing like themselves and other dot-com bubble companies. Companies in the early 2000s had very little, if any revenue, made zero profits, featured heavy losses and required immense further capital, which is why so many of them listed in that period. They also had significantly high prices because a subset of the market believed in the technology story. There was little proof of concept so their story was future based. Today’s FAANGM are a massive part of our lives, generate significant revenues and profits and are here to stay.

In conclusion, too many market commentators, investors, traders and braai enthusiasts talk about how certain stocks are overpriced or are in a bubble. The problem with this assertion is that it comes with little, if any, assessment of the company nor any calculation related to the company's fair value.

This has everything to do with how cryptic valuing a company is and how random stock prices may appear. I don’t believe that technology companies are in a bubble. I do believe that companies like Microsoft have better prospects than Apple as an investment – at current prices – but this comes after a significant process of understanding both companies in the context of the world today.

As an investor at Citadel, you can rest assured that we focus on deeply understanding companies and the market environment, not on the latest TV soundbite.

And finally, if you do invest in stocks in your own capacity, my advice would be to think clearly about the company and try and ascertain your own fair value for that stock. It is the only way to truly understand if you are getting for what you’re paying for. You would do this with a house, so why not do it with your investment portfolio?