Think stocks always reflect the underlying value of the company? Think again. Far more often than not, a stock price refracts an assumption about a company's value six months to two years down the road. That wouldn't be a problem, were it not for the fact that perception can often be skewed beyond the point of reason. Here are a couple of examples. (To learn more about what affects stock prices, check out Forces That Move Stock Prices.)
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To be fair, Amazon.com (Nasdaq:AMZN) has been overvalued since 2007, but that doesn't mean it hasn't been a successful stock; it's been a good investment despite its consistently-bloated price since that date, never reaching below a trailing P/E of 26.1 (late 2008), and priced at an average P/E of 78 for that four year stretch. Few other companies could justify such a valuation ... not that this one should. For comparison, eBay Inc., (Nasdaq:EBAY) is priced at about 15 times its trailing earnings.
The bullish argument is that AMZN is still a growth stock, and valuations don't matter as much (if at all). Funny thing about valuations though - they don't matter until they do.
In 2007, when Amazon.com shares reached a triple-digit P/E measure, valuations mattered then, and it sent the stock tumbling. Oh, the recession and bear market may be as much to blame, but what was interesting about that period is the fact that trailing 12-month earnings continued to grow for Amazon despite the recession. Investors didn't care, however, shedding these shares along with most other names.
The current scenario is more than a little alarming by comparison.
So is the market alarmed? Not a bit - AMZN shares are knocking on the door of new highs as if the earnings decline isn't even happening. At some point, however, that trailing P/E of 140 isn't going to be able to justify any amount of growth, or in this case, the new lack thereof. (To help you choose stocks, see 4 Steps To Picking A Stock.)
At the other end of the spectrum is Dell Inc. (Nasdaq:DELL), which has just produced a 12-month profits of $1.88 per share.
And here's the real stunner - at 9.05 times trailing earnings, it's also almost as cheap as it's been in years; it was only cheaper in the past decade back in 2009 when it briefly hit a trailing P/E of 6.7 (and earnings were at multi-year lows). For comparison, IBM (NYSE:IBM) trades consistently at over 13 times its trailing earnings.
Oh, and the company's prepping to buy back more than a quarter of its shares (about $7 billion worth when it's all said and done), which is only going to crank up per-share results by about 25% going forward.
Moral of the Story
This is the point where one would expect a "buy low-priced stocks with good fundamentals, and avoid expensive, struggling companies" pep talk. But you're not going to get it, and here's why: It may not work out in the end.
Dell has been convincingly on the mend since late 2010, backed by rising earnings and a falling valuation. Yet, here we are a year later, and shareholders are no better off than they were a year ago. Amazon.com has been priced at a P/E of more than 50 since early 2009 - a ridiculous valuation - and the stock's gained 177% during that time.
Is either result logical, based on all we know about sound investing? No. But it's still a reality for one simple reason: The market and its participants are selectively logical.
To be clear, this not to say we should blow off inexpensive successful companies and seek out high-priced stocks of companies hitting a wall. We just need to recognize that timing, momentum and sentiment are relevant factors as well, especially in the current environment. (For more, read The Value Investor's Handbook.)
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