At DATATISTIC we know how compelling growth stock narratives are. Young CEOs, full of desire to take over the world and with storytelling in their narrative that can convince anyone. However, the valuations of these companies often have little and nothing to do with the current numbers they show and more with the expectations behind these companies.
Although in DATATISTIC when analyzing our monthly TOP 5, we almost never have the hottest stocks in the market since they do not meet our price criteria, the relative analysis tool that we will present is very useful to know within that world of stocks that are traded relatively expensively, which are offering the best trade-off in the market.
THE FANG EXAMPLE
We are going to work with the FANG stocks as an example for an analysis that we will later extend to all growth stocks traded in the United States. Although the acronym FANG is no longer widely used (since facebook is now Meta and Google is now Alphabet), I will use this acronym as it is easy to remember.
We then have:
- F: Facebook
- A: Apple
- N: Nvidia
- G: Google
Also, keep in mind that this tool can be applied in to growth stocks in general, independently of their size or if they are profitable or not.
STEP I – VALUE METRIC
There are many indicators of relative valuation that can be built with data from the Balance Sheet and the income statement of companies. For FANG stocks, almost any indicator will serve us, since they are all companies that, although they are growing, are useful, so metrics can be built with data from Ebitda, enterprise value, income or net profits. In the case of growth companies that do not have profits, it is more frequent to build multiples from the data of their revenues. For this example we will use the Price to Sales ratio calculated as follows:
- Relative Value Metric = Market Capitalization / Last Twelve Months Revenue
This is also known as the price to sales ratio (in the LTM format). A higher number implies a relatively more expensive stock as you are paying more for each dollar that the company generates in revenue.
STEP II – FORWARD METRIC
We have already built a ratio that takes into account the current price of the share in relation to its income in the last year. But why are investors paying more for each dollar generated in some companies than in others? This is where we complement our analysis with a second indicator that allows us to relate the company to the quality of its income or to its future expectations. There are also many possibilities of metrics and multiples that we can use for this effect. In this case, we will focus on the expected growth rate of revenues for the following periods as follows:
- Revene Forecast Growth = (Revenue (t+1) – Revenue (t)) / Revenue (t)
Where t+1 denotes next period expected revenue and t would be current revenue.
STEP III – CALCULATE AND GRAPH
Once you have the the data (market capitalization and last 4 quarters revenues and the expected next period revenue), we start to tabulate and plot this data on a 2 axis graph. Usually I tend to use the X axis for a Forward looking metric or a quality metric of the company while the Y axis for a relative price metric.
STEP IV – GROWTH ECOSYSTEM
This analysis is only relevant once you upload information from all the ecosystem of growth stocks to see patterns in the data and possible companies that are mispriced in the market (either to the upside or downside). This is how the growth ecosystem looks like in current market conditions:
This analysis should be complemented with other 2-axis graphs that relate relative valuation and quality metrics of the company to validate that a stock is truly undervalued in relation to other growth stocks in the market.