Following the carnage that spread last week in financial markets, the world remains awash in valuation bubbles, manufactured by three machines.
Machine #1: “Suppressed” interest rates
Data from America’s Federal Reserve System (the most powerful central bank in the world, at this moment) shows clearly that U.S. dollar interest rates from 2009 forward remain far below normal historical levels. Keeping key benchmark interest rates low lifts values for most assets — a practice that “works” only so long as market participants believe it can continue.
In early August 2014, only the very brave believe that stretched central banks and deficit-wracked governments have much running room left. Whether at headline level, or upon deeper analysis of available data, inflation rears its head many places — soon the secular decline in nominal interest rates will reverse, and may do so abruptly.
Machine #2: Growth fantasies
When capital markets overheat, even experienced investors fall in love with unrealistic, rapid growth stories. It happened in 2000 in stock markets, it happened in 2007 in credit markets, and it is happening again both places in 2014.
Six years into a period when major governments changed important rules in hope of fueling demand, companies claiming great potential should be able to demonstrate in their published financial reports how growth will translate into financial benefits for investors.
Instead, judging extraordinarily high valuation levels for certain supposed growth stories, low information human investors and machine-driven automated traders forget fundamental principles.
One giant whose growth prospects must stand diminished compared to recent experience is Google Inc., shares of which closed at $566.07. According to Yahoo Finance, Google’s enterprise value is $332.9 billion, an amount that is 5.1 times revenues and 17.1 times EBITDA (earnings before interest, taxes, depreciation and amortization — a number loosely equivalent to cash flow from operations).
A second potential valuation anomaly is Facebook, Inc., at $72.36 a share and an enterprise value of $174.5 billion — 17.4 times revenue and 32.2 times its EBITDA.
A third wonder in the Internet advertising world is Twitter, Inc., selling at $44.13 a share with an enterprise value of $24.3 billion. This valuation is 25 times annual revenues for a business that is not yet generating solid profits, let alone free cash from operations.
Like Google and Facebook, Twitter derives its revenues chiefly from advertisers and does not yet pay any cash dividends to investors.
Much closer to actual customers, Amazon.com Inc., with a share price of $307.06, continues to punish those who bet against continued appreciation in that company’s common share price.
Recently, the enterprise value of Amazon reached $157.0 billion, which is only 1.7 times revenues but a staggering 34.1 times the EBITDA.
In 2014, Amazon is no longer a fleet upstart — eventually its growth trajectory and valuation metrics must descend towards those of Wal-Mart Stores, Inc., a “bricks and mortar” vendor with a growing online sales activity.
Much larger physically (admittedly not a clear competitive advantage), Wal-Mart barely ekes out revenue growth and has an enterprise value of $286.6 billion, just 0.6 times revenues and only 8.1 times its EBITDA.
Machine #3: Dividend greed
Some sophisticated investors hold onto common shares of large publicly traded companies because these offer cash dividends whose yield is so much higher than interest rates otherwise available.
Moreover, investors who hold high-yielding common shares may have put on their positions years or even decades ago — they refuse to sell despite rising risks now fearing punishing tax bills.
In the latest correction now in process, these yield-chasing and tax-deferring investors will ultimately rue their obstinate foolishness — far better to pay capital gains taxes and then reinvest after-tax proceeds in alternatives such as precious metals (coins or bars) then to watch as valuations plummet to earth.
Four centuries ago, Francis Bacon observed: “hope is a good breakfast, but it is a poor supper.” Investors today should ask themselves whether conditions in August 2014 are better or worse than they were in August 2008, and act prudently rather than foolishly.
• Charles Ortel serves as managing director of Newport Value Partners (NewportValue.com), which provides economic research to executives and to investment firms.
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