Amazon Shares Pierce $1,430 And Sit Firmly Above 3x 2018 Forecasted Revenue

Valuing shares of Amazon (AMZN) has always been a difficult task since the company does not at all care about short-term profit margins. Investors are left with trying to estimate, based on the company’s various businesses, how large each will get and what type of margins will likely be achieved once each reaches maturity.

Of course, such an approach becomes nearly impossible when you have no sense of which businesses Amazon will choose to enter over time (or maybe the better question is which they will “not” enter). Traditional retail was one thing, but now with cloud services and advertising revenue, margins are going to be all over the map.

I recently trimmed many of my clients’ positions, as I have done once or twice since I made the investments beginning in 2014. My methodology has been inexact, to account for the aforementioned issues regarding Amazon’s various ventures, but it generally involves looking at AMZN on a price-to-sales basis and then seeing what margin/multiple assumptions are baked into such valuations. For instance, if you think they will ultimately earn a 10% profit margin at maturity, you might be willing to pay 20 or 30 times normalized profits, which would equate to 2-3 times annual revenue.

Given the company’s growth, my personal view is that anything up to 3x revenue is at least somewhat reasonable, as I don’t see margins going above 10% given the company’s desire to remain value-based in the eyes of consumers, and anything over 30x profits for a growth company makes me nervous. And if someone argued that they will never reach 10% margins and a 30x multiple is too high, I can totally understand that view. I just think some valuation flexibility is warranted given that Bezos might actually get as close as anyone in business to total world domination.

So below I have posted updated graphs that show Amazon’s stock price over the last two decades or so (not very helpful when trying to evaluate the valuation), as well as their year-end price to trailing 12-month revenue ratio (far more helpful in doing so). Note: the 2018 data points are based on today’s stock price and consensus 2018 sales estimates.

As you can see, AMZN stock hovered around the 2.0x price-to-sales ratio level between 2004 and 2014, with a range of 1.5x-2.5x or so. In recent years, as momentum stocks have led the market higher, that number has surpassed 3x and currently sits around 3.2x.

Given that position sizing in portfolios is always important to me, this graph tells me that now is not a bad time to trim AMZN. Trading above 3x revenue would seem to indicate that investor sentiment is quite high. There may be good reasons for that, of course, but as the company gets bigger and bigger, its growth rate is sure to slow. In fact, in order to grow by the 29% rate that Wall Street analysts are expecting in 2018, total sales need to rise by a stunning $51.5 billion. That very well might happen (and acquisitions like Whole Foods will only help), but when growth slows to only 10 or 15%, investors might not want to pay 3.2x revenue any longer. In my mind, anything above 3.0x tells me to tread carefully.

What do you all think? What kind of profit margins do you think AMZN will earn at maturity (i.e. when its growth rate is in-line with the average company)? What multiple of revenue seems right to you?

Full Disclosure: Long shares of Amazon at the time of writing (even after selling a chunk at $1,400 recently), but positions may change at any time

No Bitcoin Bubble Here: Pink Sheet Listed CRCW Market Cap Hits $10 Billion

If you were an active investor back in the late 1990’s you probably remember what the climate was like during the dot-com bubble. All a company needed to do was issue a press release announcing they were going to launch a web site to sell their product online and their stock price would skyrocket. This CNET article on oldies music marketer K-Tel, which saw a 10x jump in share price in just a month back in 1998, offers a good refresher.

The current bubble in cryptocurrencies is worse, in my view, because unlike the Internet (which many will agree was the most important innovation of that generation) it is not clear that we really have any need for virtual coins, which like any collectible will see their value swing wildly based on what someone is willing to pay for them on any given day. Maybe I am just ignorant and will be proven wrong in coming years, but I don’t see why a bitcoin is any different than a piece of art, a baseball card, or a beanie baby. They all have a finite supply and little or no intrinsic value.

If you need evidence of a bubble in bitcoins and the fact that the price has gone from $3 when I first heard about them in January 2012 (Featured on Season 3/Episode 13 of CBS’s “The Good Wife” – streaming available for free on Amazon Prime Video) to $17,000 today is not enough, look no further than shares of The Crypto Company, an unlisted stock trading on the pink sheets under the symbol CRCW.

On November 15th, The Crypto Company announced financial results for the third quarter. There is no business here. Revenue came in at whopping $6,000 (consulting fees). Cash in the bank stood at $2.6 million, plus another $900,000 worth of cryptocurrencies.

How much is a company with a few million dollars of assets and no operating business worth? Well, the stock closed that day at $20, giving it a market value of $415 million (~20.7 million total shares outstanding).

But wait, that’s not the crazy part.

Shares of CRCW have surged nearly 24,000 percent in just 30 days since then, valuing the company at $10 billion. That is a bubble, folks.

 

 

 

 

CenturyLink/Level 3 Merger: 1 + 1 = 1/2 ?

A year ago my local phone company, CenturyLink (CTL), announced a $34 billion deal to acquire Level 3 Communications (LVLT), one of the leading business communications carriers in the nation. The deal was widely seen as a way to preserve CTL’s $2.16 per share annual dividend, coverage for which was coming under pressure as cable and streaming companies continue to take market share in the local consumer phone, video, and data markets. Combining with Level 3 would result in a larger player (competing nationally with AT&T and Verizon) with roughly 75% of revenue coming from business and wholesale customers.

Over the course of the 12 months it took for the two companies to close the deal, the consumer business continued to erode, and CTL’s stock price fell from $28 to below $20 per share. Competitors like Frontier, which acquired a lot of Verizon’s FIOS customers and proceeded to lose many of them, have investors fearful that the consumer business can never be repaired. Over the last month, CTL has fallen even more and today trades for $14 per share.

I happen to agree that competing with cable and streaming offerings is not a viable business model long term. CenturyLink is constantly going door to door here in Seattle peddling high speed internet. Despite general disdain for Comcast, their service is more reliable and similarly priced, so CTL really has no way of taking market share in the consumer market.

And that is why this Level 3 deal is so interesting, because the new company is 75% enterprise.  Investors and computerized algorithms treat Frontier and Windstream just like CenturyLink, even though the latter company just completed a transformational transaction that puts it in the top three corporate providers alongside AT&T and Verizon.

Perhaps the best part of the deal is the fact that Level 3 CEO Jeff Storey will take over as CEO of CenturyLink in 2019. Storey’s focus on the business customer sheds light on the future direction of the company. His track record at Level 3 since joining in 2008 and being named CEO in 2013 has been superb (revenue doubled and free cash flow went from zero to over $1 billion a year). As an investor, it is refreshing to listen to him on quarterly earnings conference calls because he talks more about maximizing free cash flow per share than he does about TV and internet bundles. If there is a better CEO to integrate these two businesses, focus on the business client, and maximize cash flow for the owners of the business, I do not know of one.

CenturyLink’s $2.16 per share annual dividend is on center stage as this new company begins to come together. Management has been firm in its desire to maintain the payout, but investors are looking past them. At $14 per share, the yield is a stunning 15%.

On the face of things, it does appear that CTL can pay this dividend comfortably from cash flow, in addition to funding about $4 billion of annual cap-ex. Pro-forma free cash flow will likely come in around $1.5 billion in 2017. Add in $1 billion of expected cost synergies, and $600 million of annual cash tax savings (LVLT has nearly $10 billion of net operating loss carryforwards) and there is a clear path to $3 billion of annual free cash flow if management can keep the business stable (business growth offsetting consumer decline) over the next couple of years. In comparison, the current dividend amounts to about $2.3 billion annually.

It appears that Wall Street is set on painting CTL with the same brush as other regional carriers who have been unable to halt the decline in their consumer-led businesses, which has promoted repeated dividend cuts. To me, the dividend itself is relatively meaningless (stocks are valued based on profits, not dividends). Today CTL’s equity is valued at roughly $15 billion, which would be 5x annual free cash flow post-synergies. Regardless of what their dividend payout ratio is, if Jeff Storey and Company can execute on the business and focus on their enterprise customers, it is reasonable to assume that CTL performs much more like a Verizon or AT&T than just another regional consumer-focused phone company.

With the stock price having been halved since the deal was announced a year ago, nobody seems to think that buying Level 3 changed CenturyLink’s business outlook. And they also do not seem to care about Jeff Storey’s track record of creating shareholder value (LVLT stock more tripled during his 5 years as CEO). In other words, the bar has been set immensely low.

Full Disclosure: Long shares of CTL as well as CTL debt securities at the time of writing, but positions may change at any time.

 

Even After 30% Decline, Equifax Shares Not Cheap

It seems that data breaches are going to become the norm globally, if they have not already, so whenever a company is hit by hackers and the stock price declines as a result, I try to take a look and see if there are investment opportunities. The best example was Target several years ago, when hackers pierced the retailer’s in-store credit card scanners and stole customer payment data. While the media would have had you believe people were going to abandon the chain for life, after 6-12 months (and many more hacks of other companies), it was business as usual.

Equifax (EFX) might be a different animal given that they are in the business of collecting credit data, but most corporations do not seem to be much of a match for professional hackers. So while it is easy to argue that their security should have been stronger than Target’s, I am not so sure that a year from now Equifax’s business will be materially harmed. It is worth watching, however, since there are other data providers corporate clients can use.

What is interesting to me is that even after large drop (in recent weeks EFX shares have fallen from the low 140’s to today’s $103 level), the stock is not cheap. In fact, it appears it was quite overvalued leading up to the hack disclosure, making a 30% decline less enticing for value investors.

I went back and looked at Equifax’s historical valuations and found that the stock has ended the calendar year trading between 14x and 23x trailing free cash flow since 2010. I would say that 20x is a fair price for the company.  But pre-hack the shares had surged more than 20% year-to-date and fetched roughly 27x projected 2017 free cash flow. So at today’s prices they still are trading at the high end of recent historical trends at ~20x.

For investors who think this hack will come and go without permanently damaging the Equifax brand, the current price is a discount from recent levels but hardly a bargain. If you are like me and would want to see how financial results come in over the next 6-12 months (to see if customers are bailing), you would want a far better price if you were going to start building a long position now. And even when you felt comfortable with the long-term prospects of the business, the current price would hardly scream “buy” at you.

The stock seems to be acting well in recent days, which suggests many are taking the bullish view. While I don’t necessarily think that is the wrong move, recent history suggests the stock isn’t worth the $140+ it was trading at prior to the hack.

Full Disclosure: No position in EFX at the time of writing, but positions may change at any time

AutoZone’s Numbers Don’t Suggest Amazon Will Replace Them Or Their Competitors

After a huge rally over the past five years, shares of auto parts retailer AutoZone (AZO) have taken a beating in recent months as investors fret over Amazon’s ability to become a full service parts supplier.

What is interesting, however, is that auto parts industry observers are far less optimistic about Amazon’s desire and ability to break into a business that often requires super fast delivery (far less than even two hours) and a huge selection of SKUs. Simply put, auto body shops suddenly dumping their relationship with AutoZone seems unlikely. In that case, AZO’s share price slump from $800 to $500 lately is probably unjustified.

There is little doubt that non-time sensitive auto-related purchases have a place in the online world. If you want to stock up on car air fresheners or get a new license plate holder, Amazon is a good place to look. But for more specialized needs, where price is not always the most important factor (getting your car back as soon as possible is), the distribution networks powering the large national auto parts retailers should still provide certainty, comfort, and value.

To see exactly how much AutoZone’s business has been impacted by Amazon, I looked back over the last 15 years to see the trend for the company’s sales per retail square foot. After all, if auto part sales are moving online in a material way, the average AutoZone retail store should be seeing sales declines. This would show up in sales per square foot since a store’s size is constant even if more stores are built.

Here is a graph of AutoZone’s sales per square foot since 2003:

Can you see Amazon’s impact in that graphic? When did they really accelerate their auto parts selection? Does it look like they are having the same chilling effect on AutoZone’s business as they are on, say, JC Penney? I just don’t see it.

For those expecting the impending doom of auto parts retailers like AZO, I think their death may be greatly exaggerated in Wall Street circles lately. In fact, it is notable to point out that over the last five years (when e-commerce growth has really started to disrupt traditional retailers), AutoZone’s revenue has grown from $9 billion to $11 billion, leading to an increase in free cash flow from $27 to $34 per share.

Full Disclosure: Long shares of AZO and AMZN at the time of writing, but positions may change at any time

Is the Enthusiasm for Charter Communications Getting Overdone?

Shares of cable operator Charter Communications (CHTR) have been on a roll lately, rising more than 50% during the last 12 months. You would think after such a big run that the company must have had a dramatic change of fortune, but really it is just a traditional cable company offering customers bundles of services while consolidating smaller regional competitors.

The story might sound a lot like Comcast (CMCSA) because they are pretty much in the same business. Comcast owns NBC Universal, so they have a content wing as well, but the two companies are the nation’s leading cable businesses in the United States, with nearly half of all U.S. households (~50 million residential customers cumulatively).

Investors would therefore likely conclude that Charter and Comcast were being afforded similar public market valuations, but you would be wrong. After Charter’s magnificent rise from $250 to nearly $400 per share (during which time Comcast shares have risen a more modest 20%), the smaller player now trades at a huge premium.

As the chart below shows, Charter fetches a 35% premium on EBITDA and a 60% premium on free cash flow:

It appears that merger chatter involving Charter may be behind a large part of the stock market move lately. Verizon (VZ) and Sprint (S) are both rumored to be eyeing a deal that would morph them into more than a cell phone provider, and perhaps adding wireless to the cable / internet / landline phone bundle would bring down costs and prove synergistic.

What investors seem to be missing, however, is that there is nothing unique about Charter’s business. The company still gets 40% of its revenue from cable video services, which are declining due to cord-cutting. The only strong business segment is broadband, which accounts for about 35% of revenue, but there is a limit there too. Population growth has slowed dramatically in the U.S. and offsetting cable losses by raising prices on internet service will only work for so long.

Charter has been an amazing investment since emerging from bankruptcy in 2009, but the stock appears very expensive. As more and more consumers move to streaming services for video content and drop their landline phones, cable companies are going to feel the squeeze. Perhaps that helps explain why a cable/wireless tie-up might make sense in the long run, but at nearly 12x EBITDA, there is very little margin for error in Charter stock. In contrast, Comcast appears to be a relative bargain.

Full Disclosure: Long shares of Verizon and Sprint debt at the time of writing, but positions may change at any time

 

Another AMD Comeback: Stock Says Most Certainly Yes, But I’m Skeptical

At first glance you might very well think Advanced Micro Devices (AMD) is having a hugely successful rebirth. Here is two-year chart of the semiconductor company’s stock price:

After so many fits and starts and promises over the last few decades, with little to show for it in the way of sustainable profitability, I had not really looked closely at the shares, even during this huge run recently. Then I read an article in the July issue of Fortune that spotlighted AMD’s bet on new chips that apparently has gotten investors’ attention.

For a company whose annual revenue in 2015 and 2016 ($3.99 billion and $4.27 billion, respectively) were the lowest out of any of the past ten years, AMD’s current market value of $13.5 billion (today’s share price: $14.39) seemed pretty lofty, but I wanted to dig deeper to see if progress is really being made. The numbers are pretty ugly:

The aforementioned revenue trend is poor:

And profitability is hard to come by. Here is free cash flow over the last decade:

Okay, “hard to come by” might be overly generous… AMD has not turned a material cash profit, after required capital expenditures, in any of the past 10 years. Looking at the two-year stock price chart again, it is hard to understand why the share are trading above $14 each.

Evidently, optimism about future products is high, despite some clear setbacks as noted in the Fortune piece. But I suspect the stock may be ahead of those rosy expectations. Including half a billion dollars of net debt, investors are currently valuing AMD at $14 billion. Revenue is expected to reach $5.3 billion in 2018 (sell side consensus estimate), which would get the company back to 2012-2014 sales levels.

So what is a best case for AMD? I decided to try and pinpoint a number in order to draw a final conclusion about the current stock market valuation. To do this I like to assume that most metrics get back to previous peak levels and see what kind of stock price I would get if things go right from here. Call it the “bull case” as many analysts do.

Using the last decade as my data set, I see that gross margins peaked in 2010 at 46%. R&D spending troughed at 19% in 2014. Corporate overhead troughed at 11% last year. Let’s plug in those expense levels (equating to EBITDA margins of 16%) and further assume that AMD can get annual revenue back to $6 billion (40% above 2016 levels and 12.5% above consensus estimates for next year). In that scenario annual EBITDA would come in at $960 million. Let’s call it a billion.

What multiple should we use on that $1 billion of EBITDA? Industry behemoth (and the competitor AMD has never been able to strongly challenge), Intel, trades at 7 times. If we give AMD the same valuation the equity would be worth $6.5 billion, or roughly $7 per share. Even if we are generous and assign a 10x EV/EBITDA multiple, we only get to $10 per share.

At over $14 per share, AMD stock currently reflects very optimistic assumptions about the company’s future growth, profitability, and valuation ($1.4 billion in annual EBITDA, at a 10 multiple, for instance). If the last decade is any indication, the odds are not great that they deliver. As a result, I am not touching the stock. In fact, for those who short overvalued and underwhelming businesses, it might be a solid candidate.

Full Disclosure: No position in AMD at the time of writing, but positions may change at any time

 

Buffett Sells IBM, Jumps On Apple Bandwagon – Blessing Or Curse?

Warren Buffett’s decision to invest a large sum in Apple (AAPL) in recent quarters was so surprising because he once regarded tech companies to be outside his so-called “circle of competence.” Then six years ago he started buying IBM (IBM) shares, which only served to confirm that the legendary investor indeed should probably steer clear of the sector and focus on the areas of the economy he knows best.

In recent days we have learned that Buffett has begun selling off his IBM position (about 1/3 thus far), but his new tech favorite is clearly Apple, which he has been accumulating so much that it now represents his second largest single stock investment in dollar terms behind Wells Fargo (WFC).

His timing with Apple appears to have been quite good, although I suspect that is more due to luck than anything. For the last year or so, Apple bulls (other than Buffett) have been touting the idea that the company is not actually a hardware company, but rather a software and services company with valuable recurring revenue. It should follow, they say, that Apple stock deserves a much higher earnings multiple than it traditionally has received (below the S&P 500 due to the perceived fickle nature of technology products, especially on the hardware side of the business).

I am not convinced that this argument makes sense, at least yet. Every quarter we hear investors tripping over themselves about Apple’s service revenue growth, and yet whenever I look at the numbers I still see a hardware company. Consider the first half of Apple’s current fiscal year (which ends September 30th). Service revenue made up 11% of Apple’s total sales, versus 67% for the iPhone, 10% for the Mac, 7% for the iPad, and 5% everything else. Clearly, Apple is not a software company.

Now I know that services have higher margins, so although they represent 11% of sales, they contribute more than that to profits, which is a good thing. But in order for software and services to really become a large contributor to Apple’s bottom line, the revenue contribution has to rise materially, in my view. And that is where I think the “Apple is a services juggernaut” thesis gets shaky.

Over the last six months, services made up 11% of total revenue. Okay, so clearly that number must be accelerating pretty quickly given how bullish certain shareholders are about Apple’s earnings multiple expansion potential, right? Well, in fiscal 2016 the figure was also 11%. In fiscal 2014 it was 10%. In fiscal 2013 it was 9%. Services thus far are not growing much faster than hardware, which actually makes sense when you think about the Apple ecosystem.

If you want more people to buy the services, they have to buy the hardware first. So maybe the two go hand in hand. Put another way, if many iPhone owners have not subscribed to Apple’s services yet, why would they suddenly begin to adopt them at higher rates in the future? At least, that is the argument for why services might not become 20 or 30% of sales over the next few years.

Interestingly, since Buffett started buying more Apple, the earnings multiple has increased. Much of that likely has to do with the prospect for corporate tax reform and the potential for the company to repatriate their large cash hoard ($30 per share net of debt) back home at a low tax rate, but some probably is linked to the idea that services are about to explode to the upside. Color me skeptical on that front.

Year-to-date Apple shares have rallied from ~$116 to ~$152 each. On a free cash flow basis, the multiple on fiscal 2016 results has risen from 12x to nearly 16x. As a holder of the stock, I am certainly happy about that, but I wonder how much more room the multiple has to rise. And will it turn back the other way if services growth disappoints or if tax reform is less aggressive than hoped? Perhaps.

If that happens, the stock price could very much depend more on Apple’s future product lineup than anything. On that front, I am nervous about the company. In recent months I have come to the conclusion that Amazon (AMZN) might be the “new Apple” in terms of tech innovation. Not too long ago it was Apple that would be first to market (the iPad, the iPhone, etc), and then everyone else would copy them (and fail). Lately it seems that Amazon has taken over that role and Google (GOOG), Microsoft (MSFT), and Apple then copy them.

I am thinking about Amazon Echo, which Google quickly copied and rumors are that Apple is not far behind in doing the same. With Amazon’s announcement this week about Echo Show I had the same thought. Dash buttons – same thing. Drone delivery – same thing. Apple is reportedly funding original TV shows and movies now (years behind the curve). The Apple Watch wasn’t first to market, etc. Oh, and the attempt to build an electric car in Cupertino? The perfect example of mimicry.

If that is the case, then Apple’s hardware growth, which has been halted, may be difficult to accelerate. And if services need to pick up the slack, there is a lot of work left there as they seem to be stuck as a percentage of total sales.

While I am not bearish on Apple as an investment – their ability to generate cash remains more than formidable – with the recent earnings multiple expansion I am starting to think about where future upside will come from. If the most exuberant bulls are right and the stock can garner a multiple a la Coca Cola (KO) or McDonalds (MCD) (20-25x earnings), that is definitely the answer. I am just not sure sure that makes sense, at this point anyway.

Full Disclosure: Long shares of Apple and Amazon at the time of writing, but positions may change at any time

Valuing Software Companies Getting Tougher As Firms Trade Short-Term Profits for Growth

There is little doubt that the technology sector is so dynamic today that investors trying to identify the big winners of the next decade or two are probably correct to be engaging in such an exercise. The proliferation of software-driven innovation is truly staggering, as are the number of new companies trying to capitalize. The IPO market is bringing new software companies to the public exchanges, ensuring there is no shortage of investment candidates.

So while there is enormous potential with these companies as we look over the next 10 years or more, it is also getting more difficult to analyze these stocks from a valuation perspective. There are hundreds of examples of investors who buy the right company – just for the wrong price – and wind up being disappointed with their return.

I say it is getting harder to determine what a fair price is for these small, high-growth companies because they have adopted what I call the “Amazon model.” The Amazon model is simply the idea that you should sacrifice short-term profitability for growth, especially in nascent industries where the first mover can oftentimes distance themselves from the competition.

Before Amazon came along very few companies were willing to have public shareholders and purposely avoid making material profits. The consensus view was that once you IPO, profits matter. And while Amazon bears tried to debunk their model for many, many years, the company’s success has proved that it can work. Simply put, if you grow fast enough and come to dominate a particular market, investors will eventually assign a fair value to the franchise you have built. If Amazon’s stock price performance in recent years does not reinforce that view, I don’t know what could.

Not surprisingly, tech companies are now copying the Amazon model and investors are okay with it. There are dozens of public tech stocks today that are growing at 20% plus annually (some much faster) and are losing money or simply breaking even. Maybe they are marginally profitable if you wave your magic wand and pretend that stock-based compensation is not a real expense (some firms have positive cash flow but if you then subtract stock-based compensation you realize they really aren’t profitable).

Valuation conscious investors who look at the financial statements of these companies cannot help but scratch their heads when trying to understand the Wall Street valuations. After all, it is hard to explain why a money-losing software company is worth 10 times forward-looking revenue.

A closer look at the income statement reveals that in addition to stock-based compensation there is another line item that is impacting profitability to a huge degree; obscene sales and marketing expenses. Why is this number so high? Because according to the Amazon model growth and market share are crucial in the short-term. As a result, the amount of money these companies are spending on sales and marketing dwarf anything we have really seen before.

Consider some of the largest, more mature software firms. Below is a list of several, along with what percentage of sales each spends on sales and marketing:

Google 12%
Microsoft 17%
Oracle 21%
Intuit 27%
Adobe 33%

Given how high the margins are on software itself (especially now that it can be downloaded rather than boxed and sold at retail), these kinds of numbers (sales and marketing costs of no more than one-third of revenue) make it relatively easy for companies to earn net profit margins of 10-20% or higher. And once investors can see those profits it is easier to assign a fair value to share prices.

The tricky part is what we see with today’s newer companies.  Below is a list of smaller, higher growth public software companies,. along with their sales and marketing expenses as a percentage of revenue:

Workday 37%
Zillow 45%
Salesforce.com 47%
Zendesk 54%
Palo Alto Networks 56%
Splunk 69%

I don’t care how cheap it is to make your software or how high of a price you charge for it, if you are spending 50% of your revenue on sales and marketing, you aren’t going to be able to make a profit. And that does not even account for the fact that these same companies are paying out a ton of stock as compensation (instead of cash) in order to be able to cover the cost of sales and marketing.

As long as investors are willing to give these companies a pass (which is likely as long as revenue growth continues), there is nothing wrong with spending money in this fashion. The bigger problem for investors comes when they try and figure out how much to pay for the stock of a company they want to invest in. In order to do you need to have some idea of how profitable the business model is. And with this much money being spent on sales and marketing, in order to maximize growth, there is no way to really know what a “normalized” level of profitability will be when the business matures and most of the market share has been divided up. Some firms might be able to earn 25% margins at that point, whereas maybe others will be 10%. There is just no way to know.

So what happens when you find a small company and love the story but look at the financial statements and see that they are losing money and then you look at the stock price and it trades for 10 times annual sales? Do you close your eyes and buy, or cross your fingers that they miss  a quarter or two and the stock falls to 5 times annual sales?

For me, it is hard to justify the former option. Amazon and Apple trade for 3x forward sales. Google and Microsoft: 5.5x. Facebook and Netflix: 11x.

For something to be worth 10x sales it really needs to be the second-coming of these tech giants. Sure, there will be a handful that make it into that exclusive group, but will most of them? How hard is it to pick and choose correctly? It is a very tough task.

So what should value-oriented investors do? Well, try and find companies that trade closer to 3-5x sales. If they will fetch a similar multiple once the businesses mature, and you think they have a lot of growth ahead of them, the growth itself will boost the stock (in the absence of multiple compression). Also look for companies that are growing quickly but maybe are only needing to spend 20-30% of revenue on sales and marketing. That could indicate they are more efficient with their spending, or perhaps they have fewer competitors (and therefore less need to hundreds of salespeople hunting down prospective customers).

Those are some ways you can reduce your risk with high multiple stocks.