Making sense of highly priced shares

In my 20 years of investing I am finding the current stock market conditions the most challenging I have ever encountered.

My investing career started during the early stages of the TMT (technology, media and telecoms) boom. The case for investing in these sectors was based on a belief in transformational business models and the rapid rates of profits growth that would come with them.

Share prices soared and valuations reached stratospheric levels. At the time valuation did not matter, the story and the momentum behind the shares were much more important. Any fund manager who refused to pay up for story stocks ran a very high risk of significantly underperforming the stock market and perhaps losing their job.

This kind of situation lent itself very well to an often quoted comment by economist JM Keynes:

"The market can stay irrational longer than you can stay solvent"

Legendary value investor Benjamin Graham made a similar observation:

"In the short run, the market is a voting machine but in the long run, it is a weighing machine."

Eventually, valuation does matter but you can wait a long time waiting to be proved right.

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In the vast majority of cases, the frothy valuations attached to some shares in the TMT bubble never came close to being justified and many investors ended up losing lots of money when the expected profits never materialised. But lots of smart, short-term traders also made fortunes by riding the momentum whilst it lasted.

The current stock market feels very similar in many ways.

I think there are sections of today's stock market where valuations are also very frothy indeed - especially for companies with rapid profits growth. The big difference between now and the late 1990s is that at least some of these expensive companies actually have some profits.

The other big difference is that during the late 1990s and early 2000s the valuations of solid, dependable businesses became very cheap as fund managers shunned them for supposedly hot growth stocks. These were rich pickings for the long-term investor who wasn't under pressure to beat the market every three months.

I don't think these kinds of opportunities are very plentiful today. Yes, there are a few pockets of decent value but most cheap shares are cheap because they are poor quality businesses facing difficult business environments. In other words, they are cheap because they deserve to be.

The valuations of established, high quality businesses are becoming very stretched given a backdrop of modest underlying growth (masked by growth in overseas profits from the devaluation of the pound) and rising inflation which should be putting pressure on valuations but doesn't seem to be.

History tells us that paying high valuations for shares is a very risky thing to do and can increase the chances of losing money. This is due to the companies behind them being unable to produce the profits growth that is baked into their share prices. Any form of disappointment tends to be severely punished with a sharp fall in the share price.

So how should investors view highly priced shares in today's markets?

Below is a selection of very richly valued shares which have made lots of money for people who have owned them over the last year(s). However well these companies have performed, and whatever the expectations of future growth, it is not unreasonable for people to ask whether the shares are too expensive and therefore have a high degree of risk attached to them.

NameCloseMarket Cap (£m)PEDebt Adj PEfc PEPE 20/6/16EPV yield (8%)EV/Sales
boohoo.com254.25p2913117.7120.287.740.610.59.7
Hotel Chocolat320p362.848.647.442.73123.14
Abcam977.5p2026.246.544.439.33127.511.2
Just Eat657.5p4481.765.964.339.164.719.611.7
Fevertree Drinks£17.001932.672.570.164.941.317.818.9
Purplebricks 381.75p1056.7 53.9

Looking at the most common valuation yardstick such as the price to earnings (PE) ratio all these shares would be considered expensive. On a trailing PE basis, you can see that all of them are also more richly valued than they were a year ago.

But if you own these shares or are trading them how confident are you that these shares will continue to go up in price? After all, the rich valuations are telling you that a large amount of future profits growth is already taken for granted. Sure, you could have made the same argument a year ago but that doesn't mean they will continue to go up from here.

One of the valuations I rely on a lot is a company's earnings power value (EPV). EPV gives me a value for a share based on its current profits staying the same forever (to read more about EPV click here). Of course, lots of companies' profits won't stay the same forever. The hope is that with good companies their profits will be a lot higher in the future. But what EPV allows me to do is get an estimate of how much of a current share price is explained by its current profits?

If we take boohoo.com as an example. We already know that it has a high PE ratio. Its high valuation is also confirmed by its EPV yield. This is EPV as a percentage of enterprise value (EV). In this case, it is telling us that only 10.5% of Boohoo's current EV is explained by its current profits with most of it explained by future growth expectations. Can it deliver these and is it already priced into the shares?

All the other shares in the table above also have very low EPV yields which again highlights the strong growth expectations baked in to their share prices. Investors should not be afraid to pay up for growth, especially for high quality companies but should perhaps set a limit on how much future growth they are willing to pay up for if they don't want to risk getting their fingers burned.

I must admit that I am too risk averse to make money from owning richly priced shares no matter how good the companies might be. I tend to set myself a limit of paying no more than twice EPV (a price/EPV multiple of 2 or less) for a share. This means, I have set a limit of no more than 50% of the company's valuation to be explained by future growth. It also means I have missed out on some massive gains on many shares but I can live with that.

SharePad users: I have used the Combine items feature to create the Close/EPVps column.

A return to common sense

Crunching numbers is all well and good but when you are weighing up a company it is never a bad idea to ask some very simple and common sense questions about it. It might help you to understand why a valuation is so high.

For example:

  • Does this company have a groundbreaking business model that can transform the industry it is operating in? Is it potentially the next Amazon.com?
  • Do analysts really understand this business? Are they underestimating the long run growth potential?
  • Are analysts' forecasts too low? Is the company being deliberately conservative with its guidance so that it can keep saying that profits are better than expected and the share price keeps going up?
  • Does the company have a big moat that will stop competitors reducing its profits, growth rate or returns?
  • Is the valuation just silly?

Regarding the companies above it might lead you to ask:

  • Will boohoo keep growing to establish a much larger and dominant position in fashion retailing with decent margins and returns on capital?
  • Can anyone stop Just Eat capturing the value of the continued growth in take-away food?
  • Estate agency - even an internet business - is a cyclical business which has historically had periods of boom and bust. Is it really reasonable that a company such as Purplebricks is worth over £1bn when it is currently loss making?
  • Why should Fevertree have a higher market capitalisation than an established business such as Britvic which makes five times the amount of money?

Riding upwards momentum

I have no doubt that most of these businesses are very good at what they do. But if you can't justify the valuations from a fundamental viewpoint then you have to accept that you are engaging in a momentum trade.

How much more momentum do some of these shares have left?

It is perfectly possible that forecast upgrade momentum can continue for some companies. If it does not then share price momentum could be at risk given the high valuations attached to them.

NameCloseNorm EPSfc Norm EPS2y fc Norm EPSRSI(20) MACD(13,26)Price % of 1 y high %chg 1y
boohoo.com254.25p2.22.93.569.514.495.60%338
Hotel Chocolat320p6.67.58.739.5-7.7782.30%60.4
Abcam977.5p2124.929.864.311.2100%53.1
Just Eat 657.5p1016.822.859.913.896.50%46.3
Fevertree Drinks£17.0023.526.228.450.91.1994.50%137
Purplebricks 381.75p-10.6-2.9-6.154.59.8686.40%179

Looking at some very simple technical indicators such as RSI and MACD might help give investors some insight into whether or not the bull run in some of these shares can continue. For example, MACD greater than zero is telling us that short-term momentum remains strong for all but Hotel Chocolat.

RSI above 70 can suggest that a share is overbought. Is RSI telling us that boohoo's stunning share price appreciation is about to run out of steam?

Calling the top of a market is not easy and is probably not worth spending too much time on. However, it is important to remember that when it comes to good investing controlling risk is just as important as securing good returns.

High valuations tend to mean high levels of risk. Recovering from losses is hard. This gets forgotten in rampant bull markets but is all too obvious when the tide turns.

I have no doubt that there will be a correction some time in the future. By examining valuations and taking time to understand them you can face the future with your eyes open rather than taking big risks with your hard earned cash.

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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.