What is valuation? It is determining what something is worth. In terms of the stock market, it’s determining what a company is worth. There are various valuation techniques that are available, some more precise than others. "Valuing a company," according to NYU Finance Professor Aswath Damodaran, also called the Dean of Valuation says, "is part science and part art." As valuation techniques require the idea of making forecasts about the future which is fraught with difficulty. They also require generating a compelling story around what the future might look like.
Let’s review a couple of very successful companies where their valuation got ahead of their price.
Back in 2000 Microsoft’s shares got as high a $58 a share (split adjusted), the company and stock had done quite well for many years leading up to early 2000. However, the future played out quite differently for shareholders who purchased in 2000. It took over 16 years for Microsoft’s stock price to get back to this previous high of $58 a share. During this 16-year period, the stock lost over 74% of its value at one point. What’s interesting, over this same time period, Microsoft’s revenue more than tripled, net income more than doubled, and earnings per share tripled as well. It’s important to consider if you bought the stock in 2000, and were 30 years old at the time, you would have needed to hold until you were 46 just get to back to even. All the while, during this same time the overall stock market gained 100%. This was a massive opportunity cost.
Do you think you could have held Microsoft stock for 16 years only to get back to break-even while the overall market did quite well?
Not many could.
Microsoft tripled its revenue and earnings per share while the stock performed horribly. How can this happen?
It comes down to valuation.
It’s PE and PS ratios in early 2000 were 73 and 30 respectively, which by most historical valuation metrics is extremely high. Over the course of the next 16 years these ratios were pushed down to as low as 8 and 2. Before finally coming back to more historically long-term averages.
It can get even worse. Cisco Systems reached a high of $80 per share in early 2000 and 23 years later is still 36% below its high from 2000. How has the underlying business done? Revenue over the last 23 years has almost tripled, and its earnings per share has grown over 500%. Back in 2000, Cisco’s PE and PS ratios were over 200 and 35 respectively. Investors who purchased 23 years ago have lost money as the company’s valuation has come down.
This drives home two important points:
These are just two examples, however, there are countless others.
-Paul R. Rossi, CFA