Note: This article on equity valuation is the first in a three-part series on the meaning and practical implications of time horizon in the stock market, U.S. public liabilities, and the climate-change debate.
With equity markets setting all-time records, many observers are puzzled by astronomical stock valuations, particularly in the technology sector. How is it rational for a company such as Tesla to be valued in excess of $570 billion when it has produced fewer than 400,000 cars at break-even levels, while a typical industrials company steadily earning, say, $3 billion in operating profit is valued in the range of $20 billion to $30 billion?
Most analysts would argue that the difference has to do with future growth. At a certain level of abstraction, this answer is correct. At the same time, it is imprecise and does not explain this year’s dramatic price movements. The disparity in growth trends between industrials and tech companies, especially the so-called FAANG stocks (Facebook, Apple, Amazon, Netflix, and Google/Alphabet), has been evident for at least a decade. Why have we only now hit market highs? Are investors in the grip of a speculative mania, as some claim?
For an answer, we can start with Yale economist James Tobin, who postulated in the 1970s that equities were undervalued when compared to the cost of starting a competitive company from scratch. At the time the Dow Jones index was trading in the range of 3,500, versus 30,000 today, so in a certain sense, Tobin was prophetic.
Updated to modern financial economics, which values a firm based on the cash it will produce in the future, Tobin’s enduring insight is that a company’s ability to sustain a competitive advantage over a long period of time depends on its replicability.
How does this approach work in practice?
A business selling products or services that can be easily replaced by other firms has relatively low value
Take International Paper (IP), the largest global producer of corrugated boxes and fluff pulp. IP generates $3 billion in operating profit and has an enterprise value of $23 billion, or 7x operating profit. IP’s virgin-fiber assets are unique and difficult to replace, because 80 percent of all corrugated boxes produced worldwide come from recycled boxes.
But that doesn’t make them valuable: Virgin-fiber paper mills have high maintenance costs, the paper market is competitive, and demand for boxes is growing at a slow pace. The result is a healthy but bounded earnings valuation. IP is expected to earn roughly $3 billion in perpetuity. If it rises to a sustainable $4 billion, shareholders will be rewarded, but not exceptionally so.
In contrast, some companies offer products so unique that their customers cannot get them anywhere else. Apple is perhaps the world’s best candidate for a truly irreplaceable asset. The genius of Steve Jobs was to insist on a walled-in, proprietary operating system. Most such efforts fail due to the comparative advantage of open-source standards. Sun Microsystems tried to build an Apple-like proprietary collection of computing businesses; today it is a distant memory.
When it works, as it has for Apple, the result is a universe of intersecting and reinforcing irreplaceable assets: High-margin phones, computers, wearables, accessories, and, most recently, chips, generate profits that in turn drive service revenues from an ever-deepening reach into the largest global spending categories.
But as with any firm, even FAANG stocks, there is a limit to valuation.
From a financial perspective, Apple monetizes its seamless offerings into a present $77 billion run-rate in operating profit. To justify its current $2 trillion valuation, Apple will need to increase its operating profit from the phenomenal $77 billion to the range of an almost unthinkable $200 billion sometime in the next decade or so.
For Apple’s stock to continue to rise, the outlook from $200 billion must be for even more sustainable profits. Investors have been wise never to doubt Apple, but it would be prudent in these extraordinary circumstances to expect the stock to stagnate for a time, at least until the path for this quantum leap in profitability becomes clearer.
The most challenging case in public markets is Tesla, the current record-holder for replacement value in comparison to current performance. At $595billion in valuation, is Tesla a bubble or a financially defensible investment?
The answer is both. On November 16, Tesla was priced at $410 per share — $380 in market cap. Less than two months later, Tesla sits at $625/share, a mind-numbing $215 billion increase in value, one that has vaulted Elon Musk to the second wealthiest person on earth.
The intervening event is the announcement that Tesla would be added to the S&P 500. Yes, indexed funds the world over must now add Tesla to their portfolio. No, this does not increase the value of Tesla. For a real increase in value, Tesla’s sustainable long-term market share would need to jump, based on information released in the last two months, from a long-term 10 million high-margin vehicles to more than 15 million vehicles. Joining the S&P 500 is meaningless in this context.
As a point of reference, the global car market over the next decade will approximate 100 million units, plus 6 million for medium and heavy-duty global truck production. Volkswagen Group is currently the largest vehicle manufacturer, at 10.7 million units, followed closely by Toyota at 9 million. In the U.S., GM and Ford each respectively produce approximately 7.7 million and 5.4 million cars each year.
In other words, Tesla’s $400 stock price assumes that Tesla will rise to the top rank of vehicle manufacturers and remain there over the long term. $625 per share moves the range into highly suspect terrain of permanently selling 50 percent or more than today’s market leaders at record margins, even as Tesla moves into the mass market.
As Musk colorfully put it recently, “Investors are giving us a lot of credit for future profits. But if, at any point, they conclude that’s not going to happen, our stock will immediately get crushed like a souffle under a sledgehammer.” On cue, Goldman Sachs this week raised Tesla’s target price to $780 per share, or $740 billion. The problem is that the target-price upgrade is based on market-penetration numbers needed to justify a $400 billion valuation. At $740 billion, sledgehammer meets souffle.
So here are the promised practical takeaways from replacement-value investing.
Investors must accept that almost no amount of new information for companies with FAANG-level valuations will materially address the viability of embedded prospects for future growth. This includes quarterly earnings announcements, company guidance, and even much-watched product-rollout and industry-analyst days. Or really anything else, save for truly earth-shattering news.
In practice, this renders the reports offered as investment analysis largely irrelevant — not because the reports lack insight or knowledge, but because the earnings embedded in tech valuations will not materialize for many decades.
Second, be wary, very wary, of awarding FAANG-like valuations based on poorly examined assumptions of irreplaceability. Zoom is the COVID-19 flavor of the month, and no doubt demand for video-conferencing has permanently shifted upward. Zoom’s market cap has reached as high as $165 billion and now trades in the range of $110 billion. Is it worth it? From a replacement-value perspective, the answer is assuredly no. And this is no critique of Zoom management, which seems to be capable and focused on the correct metric of long-term customer retention.
To justify its price, Zoom needs one day to reach at least $10 billion in sustainable operating profit. Zoom currently generates $1.4 billion in sales, headed toward $2.4 billion in 2021. Over the long term, Zoom will be hard-pressed to maintain 20 percent operating-profit margins given intense price competition from Microsoft, Google, and others, but for these purposes assume it is achievable. Zoom would need to reach at least $50 billion in sales, which will never happen, and not anywhere close. For comparison, Oracle — a longtime provider of complex, mission-critical business software — generates only $39 billion in revenues.
Third, do not expect that FAANG-level valuations will inevitably and sustainably result in an upward drift of market valuations across the spectrum. Companies whose offerings fall at the low end of the replacement-value spectrum will remain low-valued in perpetuity.
Fourth, volatility is an unavoidable consequence of vast, open-ended growth expectations. In the present, there is simply no authoritative way to disprove a Tesla valued at $300 billion versus $600 billion. Even for the Tesla optimist, a wide range in valuation results from a shift in expectations between 7 million cars at a $3,000 profit margin, or $20 billion in operating profit, and 10 million cars at $6,000, or $60 billion. And regardless of the actual long-term outcome, there is no precise guide to interim investor expectations when all major producers are offering and selling competitive electric cars.
Fifth, all assets sit on a sea of risk, one that rises and falls, independent of a firm’s individual prospects. More accurately, risk is an inclined plane, from Treasury bills through classes of debt securities, to equity markets and, ultimately, venture capital and alternative investments.
Just as in the financial crisis of 2008, the policy-makers have responded to COVID-19 by making equities less risky — through fiscal stimulus and Federal Reserve asset purchases. Increasing demand for financial assets is the best known way to ease monetary conditions when interest rates are already at rock bottom. This liquidity shows up in margin borrowing, shifts into risky equities, and the feverish effort by hedge funds and money managers to keep up with the indices. In such times, there is no realistic alternative to equity investments. And it can persist for years to come.
But it is not a permanent condition, and the de-risking tool itself is getting worn. No matter how low interest rates go, or unappealing are competing investments, there always comes a time when preserving capital is preferred to losses. It is called an asset bubble, fueled by the prospect of endless ultra-low interest rates.
Finally, it is worth remembering that policy choices do matter. Whatever one’s political persuasion, massive tax increases, rising energy costs, increased regulation, and stagnating household incomes are all bad for stock markets. Whether these factors can be offset by massive, unsustainable government transfers and the promise of endless easy money remains to be seen.
The enduring point is that when it comes to capital markets, investors the world over are willing to value businesses based on the longest time horizon possible. That is the only way you get to a $2 trillion valuation, even for a dominant Apple, or a $595 billion for Tesla as a firm just exiting the lean start-up years.
The contrast in horizon times could not be more stark when it comes to U.S. public debt and climate change, as will be seen in succeeding articles. All three are long-lived phenomena that deserve and require long-term valuation horizons. It is political failure that accounts for the difference between well-functioning equity markets versus U.S. public debts and proponents of imminent climate catastrophe.