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A stock’s “valuation” is a term investors use to describe the current or projected worth of the asset. In other words, it’s the process of determining if the stock price is cheap or expensive.
But valuations have been a bit of an enigma in recent years. Back in mid 2020, no one seemed to care about them, but fast forward to present day and you can be publicly shamed for suggesting investment in high valuation companies (cue the montage of financial analysts criticizing Cathie Wood).
It seems like when interest rates are low, valuation is an afterthought, but as soon as they rise, attractive valuation is the only thing that matters.
Reality lies, of course, somewhere in between.
One of the keys to thinking about valuation is understanding the business life cycle. Valuation metrics are just tools; some work better than others depending on the situation. A hammer is highly effective at driving nails, but a terrible tool for felling trees. The same concept applies to stock valuations.
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1. Ideation
At the ideation stage, the company is more of a dream than a reality. There are no products, no profits or revenue, and expenses are high.
The best attempt at a valuation is probably trying to define the total addressable market (TAM) in comparison to the current market cap. However, since the Dot.com bubble, it’s rare to see companies in this stage go public, so investing isn’t typically an option for traditional investors.
2. Product launch
Once you have an actual product, the ability to value the company starts to take shape. It will likely have revenue by this point which means you can use the price-to-sales (P/S) ratio.
Some examples of current publicly traded companies in the product launch stage would be electric vehicle (EV) start-ups like Rivian (NASDAQ: RIVN) and Lucid (NASDAQ: LCID) which are just starting to record sales.
Using the P/S ratio to value a stock requires contextual information about the business or industry. The average P/S ratio for the S&P 500 is around 2.8, but if you look at companies individually, you will see a wide range.
At the product launch stage, the P/S ratio will likely be high, but a good rule of thumb is to look for a ratio less than the projected revenue growth rate (i.e., if the company’s sales are expected to grow 10%/year, a P/S ratio of less than 10 suggests good value). Higher projected growth can justify a higher P/S valuation.
3. Growth
The growth stage for a company is defined by rapidly accelerating revenue. You may also begin to see emerging earnings and be tempted to use the price-to-earnings (P/E) ratio to determine if the stock is cheap, but that is usually a mistake at this stage. Even if the company manages to turn a profit, it is likely investing heavily back into the business to capture more market share, resulting in an extremely high P/E ratio.
Price-to-sales is a great metric at this stage, but using it in conjunction with other metrics like the price-to-free cash flow ratio can provide an excellent understanding of the business’ value and overall health.
Free cash flow (FCF) is the cash that remains after operations minus capital expenditure (purchases of physical assets such as property and equipment). Many investors view free cash flow as equally if not more important than earnings because it provides a clear picture of how cash flows in and out of the business.
Cloud-based data warehousing company, Snowflake (NYSE: SNOW) is an example of a company in the growth stage.
4. Maturity
As revenue growth begins to stabilize (less than 10% per year), the company enters its mature stage. Businesses can live in this stage for many decades.
The widely regarded P/E ratio is finally useful at this stage because the company has a track record of consistent earnings to examine. Investors typically look for P/E ratios less than 20, although Warren Buffet has been known to look for companies under 15. While a P/E ratio of under 15 is generally considered cheap, the ratio needs to be compared to other companies in the industry to get a sense of whether it’s undervalued or overvalued.
The 3M Company (NYSE: MMM) has been a mature business for many years and currently trades at a P/E ratio of 14.5, compared to competitors like Honeywell International (NASDAQ: HON) and Emerson Electric Co. (NYSE: EMR) which trade at P/E ratios of 23 and 20 respectively. This suggests 3M could be undervalued.
5. Decline
All companies, even the very best, reach a point where they’re no longer market leaders. This could be a result of poor management decisions, eroding brand value, or disruption from new innovation. This period is marked by declining sales and profitability which ultimately results in a death spiral.
There is no metric useful for valuing these companies because they are non-investable. New investors might be tricked into thinking these businesses are great bargains as they may have low P/E ratios, which is a perfect example of why valuation is only one aspect of analyzing a company.
Bottom line
Valuations matter. Don’t let anyone tell you they don’t. But they are not everything. Investing is about seeing the whole picture of a business, and sometimes that means buying a company that appears overvalued because of the incredible story attached to it. Likewise, it also means passing on seemingly great bargains if the business shows signs of decline.
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The Motley Fool owns and recommends Snowflake Inc. The Motley Fool recommends 3M. The Motley Fool has a disclosure policy.
