If the price of a company’s stock went up, it’s more expensive, right? Well, not exactly. Stocks are not something static. Stocks represent part-ownership of an actual and ever-changing company.
Because the underlying company changes, its value may go up or down. If a company’s share price rises slower than its intrinsic value, the stock may have actually gotten cheaper even after the price increase.
What determines intrinsic value?
Most investors agree that a company’s intrinsic value is determined by the company’s cash on hand and the future free cash flows that it can generate. This cash can be used to grow the company or returned to shareholders through buybacks or dividends.
Investors often use historical price-to-earnings and price-to-free cash flow ratios as a proxy to gauge how cheap or expensive a company is.
Facebook (NASDAQ: FB) is an example of a stock whose price has risen, but that has actually gotten cheaper based on its earnings and free cash flow multiples.
The chart below shows Facebook’s stock price against its price-to-earnings (P/E) and price-to-free cash flow (P/FCF) multiples over the last five years.
The blue line is Facebook’s stock price. In the last five years, Facebook’s stock price has climbed 220% from US$88.26 to US$282.73.
The red and orange lines show the social media giant’s P/E and P/FCF ratios over the years. As you can see, the P/E ratio has trended downwards, while the P/FCF flow ratio has remained largely flat. This is because the growth in Facebook’s earnings and free cash flow over the last five years has outrun and kept pace, respectively, with the rise in the company’s share price. As such, based on these valuation multiples, Facebook shares can actually be considered cheaper today than they were five years ago, even though the price is higher.
Buying stocks with high valuations
The Facebook example highlights that buying a stock at a high P/E ratio may still reap good returns for investors.
In the past, Facebook shares traded at much higher P/E ratios than they do today. Yet buying shares then, still resulted in solid returns.
What this tells us is that if we buy into a quality company that can grow its free cash flow and earnings at a fast rate, even a compression in the stock’s valuation ratios will still lead to strong share price performance.
Investors often confuse stock price movements as a change in the relative cheapness of a company. If the price of a stock rises, we assume it has become more expensive and vice versa. However, that completely misses the bigger picture.
The difference between a company’s stock price and future intrinsic value is what makes a company cheaper or more expensive.
We should, therefore, put more emphasis assessing whether the company can grow its earnings and free cash flow and the longevity of their growth runway, rather than looking at the recent price movement of a stock.
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Note: An earlier version of this article was published at The Good Investors, a personal blog run by our friends.
Disclosure: Jeremy Chia does not own shares in any of the companies mentioned.