I’ve done studies on the last 2 bubbles — The Internet Bubble 1998-2000 and The Great Recession 2007-2009. The one valuation measure that I found to have the most predictive ability is price-to-sales.
Price-to-Sales is the cleanest measure of company’s performance. It can not be manipulated through creative accounting like earnings or cash flow. It’s not a lagging measure like Price-to-Book (which carries assets at historical prices). In fact, I’ve found, in looking over 50 years of data (not just in bubble times), P/S to be the most reliable indicator of whether a stock is overvalued or undervalued.
Stocks with P/S over 10 has historically been the level where even the hottest growth stocks and bubble stocks have reached their peak and eventually crashed.
There has never been a stock that has had a P/S over 10, coupled with a multi-billion dollar market cap, that has produced a positive return over a 3-year period.
The average P/S of stocks in the S&P 500 (NYSEARCA:SPY) is 1.46. The average P/S of stocks in the DJIA is 1.33.
Now, take a look at the 5 stocks with the highest market caps with price to sales over 10.
1) Facebook Inc (NASDAQ:FB) has a market cap of $92 Billion and a Price to Sales of 14.76
2) Linkedin Corp (NYSE:LNKD) has a market cap of $26 Billion and a Price to Sales of 20.5
3) Tesla Motors Inc (NASDAQ:TSLA) has a market cap of almost $18 Billion and a Price to Sales of 13.1
4) Yelp Inc (NYSE:YELP) has a market cap of $3.2 Billion and a Price to Sales of 18.3
5) Zillow Inc (NASDAQ:Z) has a market cap of $ 3.1 Billion and a Price to Sales of 20.9
The average P/S of these 5 companies is an astounding 17.5! That is more than 8 times the P/S of stocks in the S&P 500 and the DJIA.
Now, let’s look at the valuation of some of the best growth stocks that actually make money.
Amazon.com, Inc. (NASDAQ:AMZN) sells for 1.95 times sales, Google Inc (NASDAQ:GOOG) sells for 5.1 times sales, and Apple Inc. (NASDAQ:AAPL) sells for 2.7 times sales.
So a basket of the 3 most profitable technology growth stocks on the planet sells for an average price to sales of 3.25. Meanwhile, the 5 bubble stocks (Facebook, LinkedIn, Tesla, Yelp and Zillow) trade for an average of 17.5 times price to sales. These bubble stocks are 5 times more expensive than the most profitable technology companies on the planet.
If you own Facebook, LinkedIn, Tesla, Yelp and Zillow, watch out because they are in major bubble territory!
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William Meade is the President of Pure Alpha Research, a hedge fund consulting and investment research firm. He is the former Director of Research at Zacks Investment Research in Chicago. Before that, he was the lead analyst at a top performing $1.2 Billion dollar institutional investment firm and hedge fund. Mr. Meade has a Masters in Applied Economics from The Johns Hopkins University. Learn more about William Meade and how he follows Billionaire Investors into stocks by visiting the Billionaires Portfolio.