Valuation matters when it comes to picking stocks

Stock valuations are near record highs — leading many to argue that valuations no longer matter. Charles Billelo warns those who agree: It’s only a matter of time before you’re proven wrong.

ELI5: The price-to-sales (P/S) multiple is a ratio used to compare stocks to determine whether one is under/overvalued.

• P/S multiple = a company’s market cap divided by its last 12 months’ sales.
• Example: Tesla has a market cap of $692m and 2020 sales of $31.5m — giving it a P/S multiple of 21.5x. In comparison, General Motors has a P/S multiple of 0.6x.
• The lower the price/sales ratio, the less a stock is valued and the more room it has to grow — making it more attractive.

A lower multiple doesn’t mean GM is undervalued. Investors must consider other factors. Investors can also find the P/S ratio with tools like Atom.

The Price isn’t Right: Alibaba or Amazon — Can you figure out which stock performed better over the past 7 years? In Sept 2014:

• Alibaba (NYSE:BABA) traded with a 24x P/S multiple and sales grew 931% since.
• Amazon (NASDAQ:AMZN) traded with a 1.8x P/S multiple and sales grew 392% since.

Amazon gave investors a higher return of 1,010% compared to Alibaba’s 98% — despite Alibaba’s higher revenue in the same period.

The Joe’s Take: Valuations matter and overpaying for a stock often leads to poor returns. In periods of market frenzy, investors are more willing to pay crazy prices — leading to even crazier valuations. In most cases, these high prices are unsustainable.