"Value investing,” the kind embraced by Ben Graham and his disciple Warren Buffett, is a theory of investing that emphasizes buying good companies trading at low valuations. When someone suggests that a stock is “cheap,” they are frequently approaching their analysis from a value investing standpoint. But some stocks aren’t cheap, by virtually any measure. Netflix, Inc. (NASDAQ:NFLX), Amazon.com, Inc. (NASDAQ:AMZN), and salesforce.com, inc. (NYSE:CRM) all trade at absurd valuations, and a value investor like Warren Buffett wouldn’t be caught dead owning these stocks.
Although these companies are expensive for a reason -- they offer some sort of brilliant technology or have cornered an emerging market -- their financial metrics are, in some cases, quite literally off the charts.
There are many financial metrics that can be used to rate a stock as cheap or expensive. Some of the more popular ones include dividend yield, price-to-earnings ratios and price-to-book ratios. By virtually all of these measures, , Amazon and salesforce.com, inc. (NYSE:CRM) are expensive.
Dividends are important
Dividends are the income shareholders get for being shareholders. Value investors like Buffett typically place tremendous significance on a solid dividend yield. About.com notes that, of the S&P 500's compounded return from its inception in 1926 until September of 2007, 95% of that return would have been earned by reinvesting dividend income.
Buffett's Berkshire Hathaway Inc. (NYSE:BRK.A) owns several dozen stocks, but nearly all of them pay a dividend. In fact, of Berkshire's top 10 largest holdings, only one (DirecTV) doesn't pay a dividend. However, neither Netflix nor Amazon nor Salesforce pay a dividend.
Netflix’s P/E ratio is 35 times the S&P 500’s
Based on Friday’s closing price, Netflix has a P/E ratio of 615.54. The broader S&P 500’s current P/E is 17.26. That means that Netflix’s P/E ratio is over 35 times greater than the broader market, suggesting that users have sky-high expectations for the company's future earnings.
Of course, P/E ratios fail to tell the whole story. Since they're based on the previous year's earnings, they only give a snapshot of the past. The price-to-book ratio compares the current share price to the value of the company's assets. Netflix has a price-to-book ratio of 13.51, compared to the industry average of 2.08 and a sector average of 1.70. Here again, Netflix's investors are placing a large premium on the company.
Of course, Netflix’s absurd valuation statistics have grown as the company’s share price has increased. Over the last month alone, Netflix shares have rallied more than 92%. Much of this rally may have owed to short-sellers scrambling to cover their bets against the company; nearly 19% of Netflix’s outstanding shares were sold short as of mid-January.
At the same time, however, investors may be willing to pay absurd prices for Netflix shares as the company has an interesting story. As Internet video grows, more and more investors are coming to believe that, at some distant future date, cable companies will lose their stranglehold over content, and consumers will make a shift from cable to Internet services like Netflix.
Netflix remains the king of this emerging Internet streaming paradigm. Despite growing competition, Netflix has been able to continue adding subscribers.
Amazon doesn’t even have a PE ratio
Currently, Amazon doesn't have a P/E ratio at all, since it doesn't really have earnings; it technically reported a loss over the last 12 months. If one calculates the figure based on its last adjusted earnings report -- $0.21 per share (multiplying that quarterly figure by four to project it out for an entire year) -- its P/E ratio would stand at a whopping 311.
Compare Amazon's forward P/E of 71.96, to Best Buy Co., Inc. (NYSE:BBY)’s forward P/E of only 7.11. When both companies are valued by their projected future earnings, Best Buy costs about one-tenth as much as Amazon. And Amazon's price-to-book stands at 14.52, more than three times the industry average of 4.34.
Like Netflix, however, Amazon has a great story. In fact, in many ways it's an even greater story than Netflix's, since Amazon’s power has been enough to push rivals (like Circuit City and Borders Books) into bankruptcy. And some may say that the aforementioned Best Buy will be the next to fall, since its stores are little more than showrooms for Amazon.
Besides eBay Inc (NASDAQ:EBAY), few other stocks that offer investors the ability to put money to work on the growing trend of online shopping -- and that trend still has a ways to go. A demographic shift should, over time, make the typical consumer more comfortable with online shopping, while advances in same-day or next-day shipping should make the option more appealing.
Sometime in the future, Amazon bulls argue, the company will be able to stop spending so much money on investment. When that day comes, patient shareholders should see a tremendous return.
Salesforce.com has long been seen as an expensive stock
Investors have been concerned about Salesforce’s valuation for years. An article in MarketWatch from Sept. 9, 2010 asks, “Has Salesforce.com become too expensive?”
When that article was written, shares of Salesforce traded near $115. It closed Friday at $169.95.
Like Amazon, Salesforce has no P/E ratio. Its forward P/E stands at 87.15. For comparison, competitor Oracle Corporation (NASDAQ:ORCL)’s forward P/E is only 11.83. Its price-to-book is 11.58, more than double the industry average of 4.83.
But again, like Netflix and Amazon, Salesforce offers investors an attractive story. The company’s colorful CEO, Marc Benioff, might be said to be the father of cloud computing. He built his company on it, challenging giants like International Business Machines Corp. (NYSE:IBM), Microsoft Corporation (NASDAQ:MSFT) and Oracle with software solutions delivered over the Internet.
Those investing in Salesforce at current share prices likely see the company as one poised to continue to reinvent the software world, crushing the establishment with cheaper and better alternatives.
Is Buffett missing out?
Just because these stocks are trading at sky-high valuations doesn’t mean that they are due for a correction. As I pointed out, Salesforce has had detractors for years and continues to power higher.
However,Buffett built his fortune on avoiding companies like these: high-flyers trading at excessive valuations. Although their cutting-edge business models might position investors for incredible returns, they also carry a high degree of risk.
To invest in one of these companies is to bet on a certain future: People switching from cable to Netflix, shoppers giving up their real carts for Amazon's virtual one, and companies opting for Salesforce and its cloud solutions over its established competitors.
In the end, those kind of bets might prove correct. But Buffett didn't build his $46 billion fortune making them.
The article Warren Buffett Wouldn’t be Caught Dead Owning These Stocks originally appeared on Fool.com and is written by Salvatore "Sam" Mattera.
Read the full transcript of the October 24 2012 Squawk Box Interview with Warren Buffett
Download the 2010 Berkshire Hathaway Annual Report
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