In early 2020 the electric car company, Tesla, saw its market capitalization rise to $92.24
billion more than GM and Ford combined.
However, according to U.S. automaker estimates, Tesla was only expected to have sold $24 billion
worth of cars in 2019 compared to Ford's $144 billion and GM's $138 billion.
So what gives?
This disparity is a good case study for understanding stock valuation.
Stocks are priced like other goods or services; it all depends on how much people are willing
to pay for them.
There are a few things that influence the value investors put on a stock.
One of the most important is earnings.
Investors buy a stock because it gives them a share of ownership in the company and the
right to share in the company's earnings.
This may come to them in the form of dividends or price appreciation.
Investors don't just buy a piece of a company's current earnings but a piece of the company's
potential future earnings.
One metric investors use to determine how much of a stock's price is based on future
expectations is the price-to-earnings, or PE, ratio.
The PE ratio compares the current price per share to the company's earnings-per-share,
or EPS.
For example, a PE of 20 tells investors that at the current rate of earnings, it would
take 20 years to recover their investment.
Another way to think of it is investors would be willing to pay $20 for every dollar of
earnings.
So, if a stock has a high PE, it suggests that investors expect earnings to grow rapidly
and that they're willing to pay a lot to get a piece of that growth.
However, stocks can have a negative P/E if the company isn't profitable.
Consistent negative earnings are often a red flag for investors, but they can be less alarming
from new or fast-growing companies that aren't yet profitable.
Could that be the case with Tesla?, On January 16 it had a PE of negative 94.73, while GM's
PE was 6.05 and Ford's was 24.97.
The fact that Tesla is valued higher than Ford and GM despite not even being profitable
suggests many investors have high hopes for Tesla's future earnings prospects.
Perhaps investors anticipate a big shift in consumer behavior toward more eco-friendly
electric cars and away from old smoke-and-choke combustible engines.
Years ago, Netflix was in a similar situation.
Instead of changing the way people drive, Netflix was trying to change the way people
watch TV.
At one point, Netflix had a PE above 650.
Over the years, that PE fluctuated drastically.
However, investors who held on to Netflix were rewarded for assuming the higher risk
because Netflix's earnings grew at a rapid pace.
Of course, that future growth is definitely not guaranteed.
High prices can be driven more by speculation than solid financial analysis.
If you were surfing the internet in the mid-90s, there's a good chance you were using a browser
called Netscape because it held 80% of market share at the time.
On its IPO day, Netscape was expected to sell for $28 per share, but high demand for company
shares delayed the trading for nearly two hours, and it opened up at $75 per share.
However, Netscape wasn't even profitable, but the focus was on future potential earnings.
Microsoft countered Netscape by giving its browser, Internet Explorer, away for free.
Netscape never lived up to the hype and dwindled over the years until it was bought out by
AOL in March of 1999.
So, what is history telling us?
To be mindful of future earnings when dealing with high-flying stocks.
For example, many companies like Ford and GM have been around for a long time and have
seen competitors come and go, and are already making their own electric vehicles.
Tesla may lose market share and some of those future earnings as well.
Even Netflix isn't out of the woods.
It's seeing rising competition from Amazon Prime, Disney+, Hulu, and more.
This is why a diversified portfolio is important.
It allows you to take risk on a stock with greater potential but also keeps the majority
of your money in safer investments.
Diversification can keep your portfolio humming even if it's not firing on all cylinders.
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