The greater fool theory is an investing metaphor that suggests that if you pay more for a stock than it is worth (intrinsic value indicates) that you are only doing this on the basis that a fool greater than you will come along and willingly pay you more. When you think about it, the greater fool theory is simply a warning to avoid taking unnecessary risk by paying too much for a stock.
Moreover, this notion is most often associated with high growth stocks that also are typically valued at high P/E ratios or other traditional valuation metrics. Classic examples would be the so-called FANG stocks, Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Netflix (NASDAQ:NFLX) and Google (NASDAQ:GOOGL) which were originally given this acronym by Jim Cramer. These four iconic tech stocks are all high growth stocks, and they all trade at very high multiples relative to average companies.
However, the most interesting aspect and questions regarding the valuations of the 4 FANG stocks is whether they are justified or not. These are extremely difficult questions to answer correctly, especially when evaluating high growth stocks such as the FANGs. Furthermore, it’s important to consider and recognize the difference between justifying historical valuations versus justifying current and future valuations. Historical information – if garnered from a credible source – is typically accurate and reliable. Future information requires making forecasts into the unknown, and therefore, less likely to be accurate and/or reliable. This is a real conundrum for investors, because we can only invest in the future. We can learn from the past, but we cannot purchase it retroactively.
In addition to the general uncertainty of estimating future growth rates we also must be cognizant of being influenced by past results. The problem is that each of these FANG companies have grown into being multibillion-dollar behemoths with Amazon and Google approaching trillion-dollar market caps. For companies this big, the laws of large numbers clearly come into play. More simply stated, it is going to be much harder for each of these companies to grow at their historically fast rates the bigger they get.
Later in the FAST Graphs analyze out loud video I will be providing an analysis of the 4 FANG stocks utilizing several valuation references. The viewers will discover that there are several ways to value stocks in general, as well as the idiosyncrasies of valuing growth stocks in particular. Because true growth stocks like the FANGs do not pay dividends, they are all about capital gain. Furthermore, investors looking at growth stocks should also recognize that due to their high growth they will trade at significantly higher valuations (P/E ratios, price to cash flow ratios, price to EBITDA, etc.) than average companies. However, these higher valuations are justified due to the incredible rates of growth these companies achieve.
Furthermore, I believe the true value of this article will be found by reviewing the video. However, I have had some followers complain that they preferred the written word. Nevertheless, I will continue posting articles primarily based on videos as I believe they provide me the opportunity to provide significantly greater insights. On the other hand, with this article covering the infamous FANG stocks I will also provide significant verbiage discussing what distinguishes growth stocks from everyday ordinary average stocks. Moreover, since I’ve written extensively on this subject before, I am simply going to repost excerpts from an article I posted on Facebook on February 26, 2016. I have placed the excerpts under quotation marks even though it is my original work, and I have provided minor edits that I have placed in parentheses to be more conforming with the thesis of this article.
“Valuing Growth Stocks: The Power of Compounding
Nevertheless, even though I readily acknowledge that investing in high-growth stocks is undoubtedly riskier than investing in blue-chip dividend growth stocks, their rapid growth can effectively mitigate some of the risk. Thanks to the power of compounding, the company that is growing its earnings very fast can bail investors out even if they overpay for the stock at purchase. Of course, this assumes that the company continues growing earnings (or revenues, cash flows EBITDA, etc.) at above-average rates. And more importantly, assumes that the investor stays the course, which admittedly is an aggressive assumption.
The Power and Protection Of Higher Earnings Growth
With the above said, this article is primarily about the power, protection and return potential that can occur when investing in growth stocks. Although I will be referencing Facebook (FANG stocks) as a quintessential example (s) of a true unadulterated growth stock (s), I contend that an analysis of Facebook (FANG stocks), past, present and future also offers important investing lessons about growth stock investing in general.
Moreover, I consider myself a dedicated value investor. Regular readers of my work will attest to the fact that I consider fair valuation the most important metric to consider before investing in any stock. Not only do I write about the importance of valuation in virtually every article I publish, I have even been given the name Mister Valuation.
In the same vein, I consider fair valuation a critical metric to consider and evaluate when selecting high growth stocks just as I do any other stock. However, as I previously alluded to, you can be more liberal with valuation when a company’s earnings growth rate is as high as (FANG stocks) have achieved. In other words, as I will later illustrate, you can actually overpay when initially investing in a high-growth stock and still make an above-average long-term total return. You do take on more risk by doing that, but due to the power of compounding, a high rate of earnings growth can still generate a significant and above-average total rate of return.
This is possible because thanks to the power of compounding, investing in growth stocks can in effect compress time. In other words, instead of taking a decade or more to double your earnings in a slower growing blue-chip dividend growth stock, you can double your earnings much quicker in a true growth stock.
To illustrate my point, I will turn to the widely recognized Rule of 72. This rule states that you can calculate the number of years it takes to double your earnings (or your money) at a given compound return by dividing it into the number 72. I have often utilized the following illustration to demonstrate the point I am making about the power of compounding and how it compresses time.
First, I will assume that the average person has a working lifespan of 36 years. In modern times this may be a conservative assumption, but as I will soon illustrate, it facilitates the math. Next, I will assume two different compound rates of earnings growth as they apply to the average dividend growth stock, and then to the pure growth stock. For the dividend growth stock, I will assume a generous and above- average rate of earnings growth of 10% per annum. For the pure growth stock, I will assume the appropriately higher rate of earnings growth of 20% per annum. The math then looks like this:
With the dividend growth stock, If I divide 10% into 72, I calculate that it will take 7.2 years to double my earnings (72/10% = 7.2 years).
With the pure growth stock, if I divide 20% into 72, I calculate it will take only 3.6 years to double my earnings (72/20%=3.6 years). In other words, earnings will double in half the time.
If I apply this math to my assumed average working life of 36 years, I get the following results:
If my earnings double every 7.2 years at a 10% rate of growth, I will get 5 doubles in 36 years (36/7.2=5).
If my earnings double every 3.6 years at a 20% rate of earnings growth, I will get 10 doubles in 36 years (36/3.6=10).
The net effect is that by doubling my average rate of earnings growth from 10% to 20% per annum, I do not generate two times the earnings by growing at twice the rate. Instead, I get double the doubles. Looked at from the perspective of the first $1 (dollar) of earnings, the power of compounding (compressing time) becomes vividly clear.
Doubling my first dollar’s worth of earnings 5 times at the 10% growth rate results in the following: $1 doubles 5 times to $2, $4, $8, $16, and finally to $32. However, at the 20% growth rate I get 5 additional doubles over the same 36 year timeframe as follows: $64, $128, $256, $512, $1024.
To put this into perspective, over my assumed 36 year working lifetime I generate 32 times more earnings by growing at 20% than I would have if my earnings grew at 10% (1024/32=32). Doubling the number of doubles over the same timeframe shows the incredible power of compounding that true growth stocks are capable of offering.
However, it should be noted that successfully growing earnings at the rate of 20% per annum (or greater as some of the FANG stocks have achieved) over a working lifetime is a rare and difficult feat. Eventually the law of large numbers comes into play and a company’s earnings growth rate will surely slow down as a result. Nevertheless, the above exercise is valuable for the insights it provides into the power of compounding.”
FAST Graphs Analyze Out Loud Video FANG Stocks
Most readers will probably realize that the 4 FANG stocks are very fast-growing companies. However, some readers may not be aware that only Facebook and Google (Alphabet Inc.) have consistently grown earnings at above-average rates. Both Netflix, and Amazon have spotty records regarding the consistency of their earnings achievements. On the other hand, all four of the FANG stocks have generated enormous growth when measured using metrics such as revenues or EBITDA.
The reason I mention this is because I often hear people talk about how crazy the P/E ratios of Netflix are and yet how inexplicitly great their performance has been. Although this is certainly true, understanding the enormous growth that these businesses have achieved removes much of the mystery of how and why they generated such high long-term returns. The following video should clarify and explain the secrets to their incredible success. Consequently, I highly recommend that the reader take the time to watch the video.
Summary and Conclusions
There are many ways to value a business and there is no one-size-fits-all. Consequently, as I always suggest, investors should take advantage of all the valuation methods at their disposal. Moreover, investors should always be aware that investing is always about the future. Although we can learn a great deal from studying and analyzing the past, the future is always associated with uncertainty.
As this specifically relates to the 4 FANG stocks, they are all clearly extremely fast-growing companies. However, their growth is not always translated into current or historical profits. This is clearly the case when examining Amazon and Netflix. On the other hand, the real-world valuation levels that Facebook and Google (Alphabet Inc.) have historically been awarded are clearly a function of their historical earnings growth achievements.
However, as I hope the video revealed, the valuation levels of Amazon and Netflix are not the mysteries that many think they are. All these companies represent extremely fast-growing businesses. As a result, all these companies have generated significant historical returns. The real question is how do their current valuations stack up to their future potential results?
Disclosure: No position.
Disclaimer: The opinions in this document are for informational and educational purposes only and should not be construed as a recommendation to buy or sell the stocks mentioned or to solicit transactions or clients. Past performance of the companies discussed may not continue and the companies may not achieve the earnings growth as predicted. The information in this document is believed to be accurate, but under no circumstances should a person act upon the information contained within. We do not recommend that anyone act upon any investment information without first consulting an investment advisor as to the suitability of such investments for his specific situation.