Despite the recovery in the US economy, the country’s stock market is overheating and many investors fear a collapse. The key measure of company valuation is the P / E ratio – the ratio of a company’s capitalisation to its annual profit.
The higher this coefficient, the longer, with all else being equal, the investment will pay off. But over time, it changes. Often the P / E is high for start-ups / growth companies and then declines dramatically. As a result, even a company with a large P / E could be a good investment in the future. But let’s see what the P / E of some of the heroes in 2020 looks like.
Amazon – 73, Nvidia – 75, Zoom – 142, Tesla – 995. These numbers are enough to ponder. If the situation continues, then even Amazon looks doubtful. Even if it paid all profits in the form of dividends, such a share will have paid off in 73 years. And there is nothing to say about Tesla.
How well-known companies survived the 1998-2000 dot-com crisis
One of the fundamental differences between today’s situation and the dot-com bubble is that most overvalued companies have a working business model. Even Tesla, mastering the new electric car market, knows roughly what it is trying to achieve: sales of a very specific product. As for the IT companies of the 1990s, many of them by the time of the bubble had little understanding of how to make money. Even the huge capital that their take-off brought them was often used in a short-sighted fashion. That is why, even according to conservative estimates, about half of the public companies that participated in the bubble later went bankrupt. However, some types of Amazon survived it and over time surpassed the past profit and price records many times over.
Buy, sell or wait?
As the review of different company histories has shown, a key factor in overcoming the stock market crisis for companies is the presence of a competent business model and reasonable management of the money received at the IPO or due to the growth of quotations. Today, many companies seem to be overvalued in terms of P / E, but some of them are on their feet, and even P / E = 73 for Amazon is not a signal to sell.
The current situation is unusual in many ways. The Fed is trying to make every effort not to disappoint those affected by the crisis. A stock crash in a situation where the country is hardly recovering from the pandemic and lockdowns would be a “stab in the back” for the population and deeply discredit both the US government and the stock market itself. In all likelihood, the collapse of the stock market in the current environment would lead to a massive transfer of capital into gold and cryptocurrencies. For the first time in decades, the United States would find itself in a very disadvantageous situation, when both the dollar and the shares of this country would simultaneously become the outsiders of world trade. Therefore, the American leadership will not allow a deep collapse.
Subscribe for more stories like this, 8am weekdays - for free!
Investors are not in a hurry to sell stocks
Realising this, investors are in no hurry to withdraw capital from stocks. Ordinary Americans, who received incentives, in polls say they intend to invest about 3.9% in stocks, and in 6.1% in cryptocurrencies. Perhaps these figures speak for themselves: confidence in the stock market has not been lost, but the market does not cause much enthusiasm either. It is highly likely that this situation will persist throughout the year, and there will be neither a collapse, nor a significant rise. It is also highly probable that the current levels of indices represent a multi-year record that is unlikely to rise significantly in 2021, while some drawdown is likely.
Thus, long-term investment in stocks, especially the ‘hype types’ like Tesla, is not worth it today. But if you have already invested, then you should not rush to sell them. A deep collapse is unlikely, and a shallow drawdown is likely to be won back in the coming years. Big and famous companies are likely to survive even a major market crash.
Even the highly overvalued Tesla is well protected from the crisis despite low sales. First, Tesla acquired Bitcoin worth $ 1.5 billion. This already at the time of purchase exceeded the company’s net annual profit ($ 690 million), and by the end of the year the amount of the “pillow” will have had a chance to grow significantly. Secondly, Tesla appears to be an important company, linked to the prestige of the American state. While Biden is more wary of giant companies than Trump, the new administration is focusing heavily on green technology, and this favours all electric car manufacturers, especially those who have achieved such prominence as Tesla. In the future, Tesla may become the same symbol of the United States as Ford and General Motors.
Don’t forget about diversification in this environment
However, you should never forget about diversification. As great as the prospects of individual companies may look, they are not insured against bankruptcy. It is much more difficult to bankrupt a portfolio of tens or hundreds of shares.
Maybe these companies are really overvalued, but overall is the market adequately priced? Let’s look at the average P / E for the S&P 500 (top 500 US companies). It’s a little over 40. Is it a lot or a little? This is significantly lower than that of the listed companies, but 40 years is also a lot for a payback, and this is only with a 100% dividend. So it makes sense to also look at the P / E history for that index.
From 1896 to 1998, the P / E of the S&P 500 did not rise above 25. Since then, the ratio has only only been higher than 25 on three occasions: 1998-2002 (the dot-com bubble), 2009 (deflation of the real estate bubble) and 2020-? (covid crisis). Already, the P / E of the S&P 500 is above 40, as in the craziest moments of the dot-com bubble. This figure was significantly higher only once in history – in 2009.
So, as history shows, 40 and above is an abnormally high P / E value for the S&P 500. There were only three times in the market’s history this has been achieved, and both of the previous times were not just in crises, but the most difficult moments of those crisies. Of course, the situation is different today, and high P / E values do not guarantee a close collapse. In particular, the Fed’s promise to keep zero rates until 2023 works in favour of maintaining the abnormally high valuation of companies. But a lot also depends on the companies themselves.
Pets.com. Site with services for pet owners. In an IPO in February 2000 (at the peak of the bubble), he raised $83 million, but spent a significant chunk of it on TV ads featuring a toy dog. The site sold dog food and cat litter, but did not succeed. In November of the same year, the company went bankrupt.
Five dot.com bubble stocks investors can learn from
Social network, one of the predecessors of such giants as Facebook. It was created in 1995, and in 1998 entered the Nasdaq stock exchange, having risen in price by 7 times on the first day of trading. The company quickly took the path of expanding its business in the direction of computer games: it bought Computer Games magazine, and the happypuppy.com site, as well as the Chips and Bits store. But it didn’t help when the bubble collapsed. In the wake of general pessimism in 2001, Theglobe’s share price plunged from a record $ 97 to $ 0.16. The company’s capitalization fell 20 times, and it was removed from the Nasdaq. The company closed its parent site and laid off 50% of its employees. It completely ceased operations in 2008.
As we already know, the fate of this company was better, although its rise and fall in 1998-2001 was also impressive. At the beginning of 1998, at the very beginning of the bubble, its shares were worth about $5, and at the peak of the bubble at the end of 1999 they were already reaching $355. However, already in 2001, after the bubble, the shares fell to $6. Although Amazon continued to work, it was not easy for it to break its old stock price highs. This only happened in 2013, when the share price was above $400. Amazon stock is now more expensive at over $3000. As for the P / E ratio, it has changed a lot over the years, but it has never been very small. From the dot-com bubble to 2019, it fluctuated in the range of 34-250, although in 2012-2013, amid problems with profitability, it rose above 700, even reaching 3600, and in some quarters it was completely negative. All this did not stop investors from getting excellent returns on investment in subsequent years, and the current 73 is more the norm for Amazon than overvalued.
This world-renowned manufacturer of IT equipment is interesting because, although it has successfully survived the trials of crises, it has not yet surpassed the 2000 price record it set. At the beginning of 1998, the company’s shares were worth about $10, and in March 2000 – already $80. At that moment, Cisco became the most valuable US company with a capitalization of more than $500 billion. However, by September 2002, its stock slipped back to $10. The company continued to operate, but its stock price still well below the previous record. Cisco stock only surpassed the $50 bar in 2019. Cisco shares are now worth around $53. By the way, unlike many other companies, Cisco today has a moderate P / E equal to 22. In other words, the shares are well-secured with profits and, most likely, they have room to grow.
This is another hardware manufacturer, but with a very different story to tell. Unlike many other heroes of the dot-com bubble, this company was founded a long time ago – in 1895. Moreover, by Alexander Bell himself, the inventor of the telephone. Nortel made telephones, gramophones, radio equipment, equipment for the first-ever sound cinemas, etc. However, in the late 1990s, the company had problems with profitability, but this did not prevent investors from taking its share price to C$124 during the bubble ( capitalization – up to C$398 billion). Along with Cisco, Nortel became one of the largest in the world by market capitalization, but the collapse was catastrophic. In 2002, Nortel shares began to cost C$0.47, and capitalization fell to C$5 billion. Director John Roth left the company, convicted of speculating in options for C$135 million for personal needs. The new management reorganized the company, laying off two thirds of its employees, but failed to achieve stable profitability. In 2013, the company went bankrupt.
This site was originally focused on postal services including printing, delivery, etc. But like many others, it had problems with profitability. In 1999, the company had a loss of $56 million, but amid general optimism, investors believed in the company, raising its stock to $88. As in many other cases, this belief was short-lived. In 2000, the share price plunged to $2.25, and the company’s loss amounted to $213 million. Almost all the top management talent left Stamps.com. However, the company later managed to find a suitable business model and stay afloat. In 2000-2006, Stamps.com tried such services as delivery of goods, printing tickets and coupons, and issuing exclusive photo stamps. Later, it again focused on its own postal services. In 2015, the company’s stock price exceeded $100, and now shares are trading near $200. The P / E ratios in the years since the dot-com bubble have fluctuated in the 8-38 range, remaining modest most of the time. Now it is 21; that is, this company, like Cisco, is not overvalued.
You should never forget about diversification. As great as the prospects of individual companies may look, they are not insured against bankruptcy. It is much more difficult to bankrupt a portfolio of tens or hundreds of shares.