The sell-off in the markets seems completely overdone and could be creating a very compelling opportunity. With valuations in the FANG stocks or Biotech (IBB) names that are perceived to be at high levels, which are not.
The S&P 500 Healthcare Index is currently trading at 917.95, and 2018 forward EPS estimates are expected to be $58.80, up 16 percent from 2017. At current levels, the Healthcare Index (XLV) trades at 15.6 times 2018 estimates. The S&P Information Technology (XLK) at 1,126.21 currently trades at 20 times 2018 EPS estimates $55.83.
(Historical P/E Data Provided by Dow Jones S&P Indices)
In fact, as the chart above shows the S&P 500 at its 2017 forward multiple is trading at its lowest Operating P/E ratio since 2014. The Healthcare sector is trading at levels not see since 2012, while Information Technology is at its highest level over the last decade, but we know that numbers come down when using 2018 multiples.
A Closer Look at FANG
As “overvalued” as the FANG stocks are reported to be they are trading at their cheapest forward Multiples in some time.
Alphabet (GOOGL) and Facebook (FB) are trading at forward multiples equal to or cheaper than historical levels.
How can the FANG names be overvalued if their valuations are at or near their lowest historical levels? They can’t be. That is because, for as exaggerated their multiples appear to be, these companies are expected to grow at high-speed rates.
Just look at the expected revenue growth rates that are going out until 2019. These are monster growth rates with Alphabet’s revenue expected to grow 94 percent over the next three years.
As much as revenue is projected to increase, earnings are expected to grow just as fast.
Then you wonder why Netflix trades at forward PE ratio of 76? 662.7 percent expected EPS growth over the next three years? Come on. This is why investor pay premium’s for these company’s because you aren’t going to find this type of growth rates anywhere else.
FANG Growth Rates
When you figure out the Current Annual Growth Rates for each of these companies EPS from 2017 to 2019 you find:
Netflix CAGR: 94.4 percent
Amazon CAGR: 56.8 percent
Alphabet CAGR: 11.5 percent
Facebook CAGR: 23.7 percent
Using those three-year growth rates you can then find their Price/Earnings adjusted for growth are currently
Facebook is at 0.99
Amazon is at 1.42
Alphabet is at 2
Netflix is at 0.81
Which is not as expensive as they look when EPS estimates going out are actually rising on all of these companies over the past several years. Which if the trend of rising estimates for EPS continues then these multiples are only to get lower over time as well.
We are seeing the same trend occurring in on the revenue side of the equation as well.
As we explored in our last article Biotech is in the same boat. Celgene (CELG), Alexion (ALXN), Regeneron (REGN), and Vertex (VRTX) are also expected to have monster revenue growth over the next three years.
But of course, these companies are undoubtedly overvalued? (Sarcasm)
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Biotech Growth Rates
Then of course when you adjusted these companies for growth we again find CAGR with big growth rates:
Regeneron CAGR: 19.1 percent
Celgene CAGR: 21.0 percent
Vertex CAGR: 82.4 percent
Alexion: 23.2 percent.
Then we again adjust for growth using the PEG
Regeneron PEG: 1.75
Celgene PEG: 0.71
Again, like the FANG stocks, the trends for these companies have been rising EPS and Rising revenue expectations, with the exception of Vertex which has seen some modest EPS estimate declines.
Again rising revenue and EPS expectations are likely to help drive multiples which whether adjusted for growth or are fairly cheap within Biotech names.
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So although many stocks, sectors, and indices may seem grossly overvalued the truth is they are not. When we adjust stocks within the sector for growth prospects we see those valuations come way down. Given the upward revenue and EPS bias in many of these names, the appearance of “overvaluation” is likely only to continue to decline should stock price appreciation not drastically outpace revenue and EPS growth expectations.
The next time you hear someone say the market is overvalued do your homework and decided for yourself. Just because a stock is trading at a high multiple doesn’t mean it is overvalued. You should judge a company’s valuation by how much growth it will provide and in some cases you might just find they are cheap.
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Michael Kramer and the clients of Mott Capital own shares of CELG , GOOGL, and NFLX
Mott Capital Management, LLC is a registered investment adviser. Information presented is for educational purposes only and does not intend to make an offer or solicitation for the sale or purchase of any specific securities, investments, or investment strategies. Investments involve risk and unless otherwise stated, are not guaranteed. Be sure to first consult with a qualified financial adviser and/or tax professional before implementing any strategy discussed herein. Upon request, the advisor will provide a list of all recommendation made during the past twelve months. Past performance is not indicative of future performance.
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