What local investors need to know
Investors cannot look at valuations as they would their local investments. Many seem completely overvalued, but need to be analysed differently.
Anchor Capital’s Sean Ashton says while some of the companies it is invested in, which include Amazon, Facebook, Alphabet, Priceline Group, PayPal, Activision Blizzard and Apple, may trade at elevated P/E multiples of 25 or more, “we do not agree that they are all to some extent overvalued”.
He adds: “Our assessment of value is the extent of cash generated by the business and the expected growth in these cash flow streams, discounted at an appropriate discount rate.
“For example, while Facebook trades at a forward 24 P/E multiple, unlike tech companies of the late 1990s, this business generates exceptional cash flows and our discounted cash flow valuation suggests further upside.”
Ashton says that in the US tech space there is often a very large divergence between reported earnings and “non-GAAP” (generally accepted accounting principles) or adjusted earnings – which typically relates to adding back non-cash charges such as share option expenses or amortisation of intangibles.
“Because of this, we would caution that investors pay close attention to the level of free cash flows of the company being researched, and that the valuation is well underpinned by free cash flow generation.”
Amazon would be an exception as it has deliberately invested heavily in growth at the expense of profitability.
“Very importantly, investors should ensure they understand the business model of the company in question, how it generates its revenues (or is likely to) and whether they are comfortable that the business model is sustainable.
“We would caution strongly against blindly following the next ‘hot IPO’ [initial public offering] without first getting a handle on these issues.”
Coronation’s Marc Talpert says investors should not ignore valuation. “Valuation always matters, but you mustn’t get too fixated on short-term valuation metrics like a one-year forward P/E. Rather look at how long can they grow above normal and what margins the business can ultimately generate.”
For tech companies, it is important to look at the quality of management and the extent to which the team focuses on the long term. “While they have been disruptive, there is no saying they won’t be disrupted themselves. It is important for them to reinvest in innovation,” says Talpert. “That is what companies like Amazon have done so well. They operate with a sense of paranoia that they are going to be disrupted and constantly reinvent the business. “Sometimes these companies don’t generate profits [and as a result] investors can come to the wrong conclusion. Sometimes the business model involves spending a lot and creating a barrier to entry, which down the line will lead to a significant return.” firstname.lastname@example.org
"While Facebook trades at a forward 24P/E multiple, unlike tech companies of the late 1990s, this business generates exceptional cash flows and our discounted cash flow valuation suggests further upside."
Sean Ashton Chief investment officer at Anchor Capital