From Joe Frankenfield at Saga Partners:
Some may look at the valuations of certain companies today and think they have completely parted from fundamental realities given the high multiples relative to recent fundamentals. This is too simple an analysis. A top-down analysis based on historical average valuation comparisons will likely prove ineffective.
The only insight that comparing a company’s market price to its past year’s sales and cash flows provides is the ratio of the price to past sales and cash flows. Analysts have used these simple ratios as proxies or shortcuts to value a company, but as the definition of intrinsic value states it is the future net cash returned to owners that matters.
If every company within the market had the same prospects, then this analysis could work, but that is not the world we live in. There is an enormous range of companies with different economic characteristics, qualities and outlooks. The difference between an exceptional business with strong prospects and an average one with lacklustre ones is huge.
While many of today’s high valuations may not live up to the expectations baked into their prices, some are likely more than justified by their prospects, just as some companies with low multiples may be overvalued. Only by assessing a company’s long-term outlook can one have a decent understanding of its intrinsic value.
It reminds me of a passage from Phil Fisher’s 1958 book, Common Stocks and Uncommon Profits: “As it became obvious that the automobile was largely to displace the streetcar and the shares of the once favoured urban railways began to sell at ever lower price-earnings ratios, it would have been a rather costly thing just to be contrary and buy streetcar securities only on the grounds that because everyone thought they were in a declining age, they must be attractive.”
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