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  • Writer's pictureIshfaaq Peerally

How to VALUE STOCKS in this Stock Market BUBBLE

The other day, I came across a tweet from Venture Capitalist Chamath Palihapitiya, who is also chairman of Virgin Galactic, about how to spot a bubble.

Chamath Palihapitiya said that there are 6 stages of stock market bubbles, according to how stocks are valued:

1. Multiple of Free cash flow

2. Multiple of EBITDA

3. Multiple of revenue

4. Multiple of ARR

5. Multiple of Bookings

6. Multiple of GMV

Companies are not being valued on Free cash flow (FCF) anymore today as many companies are going to lose money, they are not even being valued on sales as many companies will have zero sales for months.

The father of value investing in his book, The Intelligent investor, he talks about valuing companies based on multiples of Earnings per share (EPS) and book value, that is, PE ratio and PB ratio.

Warren Buffett prefers valuing companies on discounted free cash flow, what he also calls owner's earnings. It makes sense since the total free cash flow that the company will produce over its lifetime should be its real intrinsic value. Today, Warren Buffett still uses these multiples as you see him investing only in companies with huge free cash flows such as Apple $AAPL . But Price to book ratio doesn't work that well anymore since many companies have much in intangible assets, which are not accounted on the balance sheet.

But Warren Buffett is a value investor, if you're a growth investor, maybe it makes sense investing in a company with negative free cash flow today if the company will have positive free cash flow in the future. That's why many companies such as Netflix $NFLX and Tesla $TSLA are being valued on EBITDA today. Today, Tesla is being valued at 85X EBITDA. There is nothing wrong in investing in a company not profitable in the short term, but the real question is whether investors will still value Tesla at 85X EBITDA in the future.

One company being valued on multiples of sales today is Amazon $AMZN . Even if Amazon is growing at a fast rate, it still has a very low margin and revenues are not equal to profits. Again, you cannot know for sure, for how long these crazy multiples will go on.

In 2000, Microsoft $MSFT was being valued at 80X Earnings, the revenues and earnings kept growing but when the dotcom bubble crashes, investors were not willing to give the same valuations on Microsoft anymore and the stock crashed. It recovered only after 16 years.

ARR, booking and GMV applies mostly to subscription-based businesses. But these are not real sales. They are just numbers. What matters if you're investing in a company is sales, then ultimately free cash flow.

If you're investing in a company just because you expect the stock price to go higher because someone else wants to pay for it without any fundamentals, that's not investing, that's speculating. That someone else also thinks that someone else will pay at any even higher price.

Even in this stock market bubble, what really matters in the long-term is free cash flow, focus on that. Over the long-term, how much cash a business is producing is what really matters.

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