Remember earnings? As the shocks of 2020 slide into the past, Wall Street has spent the last few weeks figuring out how to get back on the old quarterly rhythm that dominates normal market life.
Earnings dropped into the background for many investors over the past year. There just wasn’t a lot of point in comparing business conditions in the depths of the pandemic lockdowns to what had gone before or projecting them into the future.
In isolation, the numbers were just noise. But now, a year into the pandemic, we can start connecting the data dots again to find the trends driving the post-COVID-19 economy.
Remember Earnings? Warren Buffett Does
Everyone from Warren Buffett on down knows how this works. Once you can forecast corporate cash flow with any degree of accuracy, you can determine which stocks are undervalued relative to their market peers.
And when you have that kind of clarity on future growth rates, you know which companies are expanding fast enough to support premium valuations today.
Some sizzle stocks are simply overbought and will ultimately collapse. Others are making the kind of progress that can keep rewarding shareholders far into the future before the math no longer makes sense.
Three months from now, the quarterly numbers are going to be extremely important. That’s why I want to use our time today to reset the parameters and refresh our expectations on where stocks “should” trade relative to their fundamentals.
Remember Earnings? Back To Wall Street 101
The S&P 500 currently looks historically rich at 22.5X projected earnings. While the Fed’s zero-interest-rate cushion helps to justify that multiple, the market as a whole is still a long way from “normal.”
Some areas of Wall Street have gotten farther ahead of their fundamentals compared to others. The financials, for example, feel reasonable at a little under 15X forward earnings, while the technology sector is significantly more expensive.
Elsewhere, it only takes one or two big companies to distort all the metrics. Consumer discretionary stocks are even richer than technology right now, but that’s not because retail chains are in great demand among investors.
The sector’s huge 29X multiple is really a factor of Amazon.com Inc. (NASDAQ:AMZN) and newcomer Tesla Inc. (NASDAQ:TSLA), which together account for a staggering 40% of the market capitalization in the overall group.
Remember Earnings? Tesla Has a ‘Staggering’ Valuation
After all, AMZN commands a 73X multiple and TSLA has run up to a staggering 211X projected 2021 earnings. In the face of these numbers, all the other retailers, car makers, restaurants and hospitality companies are profoundly undervalued.
Similar conditions apply in the communications sector, where Alphabet Inc. (NASDAQ:GOOG) and Facebook Inc. (NASDAQ:FB) have eclipsed all the other networks, game companies and even the massive telecom and cable carriers that keep all the content flowing.
FB is currently a little cheaper than GOOG on a pure earnings basis, but neither presents an obvious bargain at these prices.
Remember Earnings? Disney’s Valuation is Magical
Of course, Silicon Valley isn’t the only place stocks have gotten ahead of their cash flow. Walt Disney Co. (NYSE:DIS) has run up to above 100X anticipated 2021 earnings on the hope that a successful streaming channel will make up for weakness elsewhere in the company.
Factor out all the froth and on a pure earnings basis, DIS would be a $45 stock if investors were pricing it like FB. If you think FB is built on hype, this basic calculation should scare you.
Yes, DIS has decades of brick-and-mortar success to fall back on when streaming hits a wall. But right now, the theme parks are shut down and the movie theatres are empty.
With that drag on the balance sheet, DIS even looks rich compared to streaming rival Netflix Inc. (NASDAQ:NFLX), which commands only half the earnings multiple.
Are you leery of NFLX at this price? DIS is twice as expensive once you strip out the hype. Maybe both stocks can keep rallying indefinitely, but statistics favor shareholders who buy relatively cheap and hang on.
Remember Earnings? Great Growth Expectations
High multiples historically emerge when a company is growing into its current valuation on an accelerated timeline.
NFLX, for example, is facing plenty of long-term challenges, but for now the company is still expanding fast enough to raise the bottom line about 60% in the coming 12 months. All you need to do is wait a year and the fundamentals will look a lot less stressed.
DIS, on the other hand, is still looking at earnings deterioration over the coming year. A negative growth rate rarely justifies this kind of multiple for long.
This is important when you look at stocks with a strong go-go growth reputation, but the numbers no longer support that story. GOOG is not a buy at 30X earnings and only 20% anticipated growth in the coming year.
Remember Earnings? Apple and Microsoft Valuations
Apple Inc. (NASDAQ:AAPL) has only marginally better numbers. Microsoft Corp. (NASDAQ:MSFT) looks a little worse on a growth-adjusted basis.
Traders caught up in the post-pandemic euphoria naturally gravitate toward these stocks because of their history of transforming whole industries as they grew into the biggest stocks on the planet. But the math simply doesn’t hold up.
Sooner or later, math always rules on Wall Street. For now, euphoria is in control and we can all share the fun.
Remember Earnings? Look for Sustainable Growth Rates at Reasonable Prices
But when the euphoria ends, give me sustainable growth rates at a reasonable price. Give me big banks, resilient retailers and the tiny tech stocks of tomorrow.