On the eve of a day that could be one for the record books, let’s take a look at how one of the world’s most famous companies can see its value go down by $120 billion in just hours.
Facebook, one of the largest companies in the world, is currently down 20% in trading tonight:
That means a $100,000 investment in Facebook is worth $20,000 less after just a couple hours.
The company had a market cap of $630 BILLION dollars just hours ago. Now? $500 billion. $120 billion in value gone in a minute. If this stands it will be the largest single day loss of value for a company in history.
Who knows what will happen over the next few hours, days, or months. Regardless, this will be lesson for many investors on what can happen with high multiple stocks, even when they report 42% revenue growth, like Facebook just did.
So what can cause one of the largest companies in the world, one ingrained in our everyday lives, to drop 20% so suddenly?
Betting on The Future
Investing is a game of future expectations much more than a reflection on current events. If you are making your investing decisions based on something that happened last year, you are behind the 8-ball.
Facebook is one of the premier businesses in the world. They have billions of users, are growing rapidly, and generate billions of dollars in profits.
But everyone knows that.
Succeeding in investing in Facebook (or any company) is not necessarily about estimating what will happen in the future, but instead estimating what is priced into the stock, and deciding if Wall Street’s expectations are reasonable.
This is the reason that a company like Dominos Pizza Company can see its stock rise just as fast as Facebook’s:
No one is going to argue that Dominos is as great of a company as Facebook. But what happened is that investors were pricing in no growth in Dominos stock 8-10 years ago, so when the company began beating (very low) expectations, traders re-priced the stock based on higher future growth, giving the company a higher PE, or Price-to-Earnings Multiple.
It is tough to tell from the scale, but Dominos P/E Ratio has gone from about 12 to 37 over that time.
6 years ago, Facebook traded at a P/E ratio of 200+.
That is buying a business for 200 years’ worth of profits. At that multiple, a neighborhood gas station that makes $100,000 per year would be valued at $20 million! You would be crazy to pay that.
Unless you believed that the gas station would make $1 million a year 5 years from now.
And that is exactly what Facebook investors were pricing in. At a 200 PE Ratio, investors were pricing in huge growth rates in Facebook’s earnings!
Everyone knew Facebook was growing, but that is not what you needed to base your investment thesis on. What you needed to consider was whether or not Facebook would grow more or less than what was priced in. And Facebook was pricing in big growth.
That is, until today. After this earnings call, investors fear that the best days for growth at Facebook are over, and a high multiple is no longer warranted.
Calculating Growth Expectations
In 1950 Benjamin Graham, who would go on to mentor a kid named Warren Buffett, had just written what would become the most famous investing book of all time, The Intelligent Investor.
And in that book he gave a simple equation to help investors calculate the growth rate that investors are projecting for a company:
Growth = (Stock Price ÷ Earnings Per Share) – 8.5, all divided by 2.
So prior to today, Facebook was trading at $217 a share, with earnings of $6.04. Telling investors that the market was pricing in about 14% growth for Facebook.
It doesn’t matter that Facebook posted 42% revenue growth last year. What matters is what investors think it will do over the next 5 years. And when they see charts beginning to top out, hear management guidance warning of a slowdown, or fear regulatory actions could be forthcoming, 14% growth seems a little less likely:
So what if after seeing these numbers and hearing management speak at the quarterly conference call, you think Facebook will grow earnings at just 10% in the future instead of the 14% that had been priced in?
That would put the shares at about $175, right about where they are trading now.
Hopefully this helps show how expectations are baked into a company’s stock price. Everyone knew Facebook was growing, the decision that investors needed to make was would Facebook grow faster or slower than 14% over the foreseeable future.
Today, those that were pricing in slower growth are correct.
In Conclusion – The Risk Of High Multiple Stocks
A high multiple for a company’s stock acts just like leverage. When the going is good, rises in the stock are amplified. Not only does a company’s value increase when it reports higher profits, but if traders sense higher future growth, a higher multiple will be applied to today’s value, boosting the company’s value by much more than the value of future earnings.
Investors pricing in a 1% rise in future growth will cause a stock to rise much more than 1%.
But on the flip side, a reduction in growth expectations hits the company’s shares very hard. A reduction in expected growth from 14% to 10% means much more than a 4% decline in stock price.
And that is exactly what we are seeing with Facebook this evening.