Do valuations matter?

   Since the start of the financial crisis back in the fall of 2008, I've become a CNBC junkie. For anyone not familiar with the channel, there a couple important things to be wary of. On the positive side, the channel offers the most comprehensive news on the economy and markets, while engaging the biggest name in the business on a daily basis. On the negative end, as with most media, the severity of the news and effects are often overstated. In defense of CNBC and its analysts, the shows rely on their ability to interpret each market move as cause and effect with current news. This is an unreasonable expectation from the start, especially in a forward looking environment often impacted simply by change in emotions.

   Its also critical to recognize that within the investment community there is a real premium on maintaining the status quo, which forces analysts and advisers to generally converge around a common outlook. Considering the volatility experienced during the past couple years, another crucial recognition is that most commentators on the network are providing investment outlooks for the next few weeks or months at best. This is probably the best example of how long-term investing has fallen out of style. Due to this, investors with a time horizon greater than a year or two, will likely find much of the recommendations worthless. Despite this weakness in programming, writing off the accompanying discussions would lead to missing out on very valuable information. If we assume that today's trading volume is dominated by these individuals, funds and institutions, than understanding their views offers significant insight into the current market psychology.

   Thursday afternoon, the "Fast Money" show offered a wonderful example of the strengths and weaknesses of the network. A brief overview of the show is that each day a panel of four traders explain their views on the day's action and best trading ideas. The traders are part of a small group, likely selected for their impressive track records and entertaining personalities. Although I don't frequently act on any of their trading recommendations, I find the conversation to be very insightful. Thursday was a perfect example of the dichotomy between long-term investment rationality and a short-term trading mentality. As the traders discussed the impressive market gains on the day, the general conclusion was that investors have to be long the market at this point. Despite concluding that markets will likely continue moving higher, the group was also  nearly unanimous that the longer term outcome (likely meaning a few years) would be disastrous. This view, maybe surprisingly, has actually been offered frequently on CNBC over the past several months. If this view turns out to be correct, it's doubtful that all those buying in the dash higher will be able to sell before the crash occurs. That is a discussion for another day though. Getting back to "Fast Money", my favorite comment Thursday came from Guy Adami, a frequent and entertaining contributor. Speaking about some recent high flying stocks, Guy suggested that valuations no longer seemed to matter in the names. Enticed by this statement, I decided to take a look into the current valuations on some of the biggest, recent gainers.

    [Earning per share (EPS) data from 2006-2009 was obtained from Google Finance. EPS 2010-2012 estimates were gathered from Bloomberg and reflect the average of many analyst estimates. Growth numbers reflect expected percentage changes in earnings from the previous year. Average growth reflects the average of the two growth percentages. Price-to-earnings multiples (P/E) are calculated using the closing price from Friday (11/5) and respective earnings estimates.] 

   A quick overview of the earnings data and valuations provides some intriguing and unexpected insight. Based on expected earnings growth over the next two years, most of these stocks do not appear widely overvalued on a 2011 or 2012 P/E basis. In fact, the top 4 listed, Amazon (AMZN), Priceline (PCLN), Netfilx (NFLX) and Baidu (BIDU) appear pretty fairly valued. On the other hand, Chipotle (CMG), Salesforce.com (CRM) and Wynn Resort (WYNN) seem to be trading at rich valuations.  For example, if CRM simply meets expectations over the next two years, investors will need to pay 60 times 2012 earnings for the stock to merely maintain its current level. As for the other two securities on this list, while Las Vegas Sands (LVS) appears cheap at current valuations, the deterioration in earnings  and significant losses over the preceding few years implies considerable risk and volatility in future estimates. Meanwhile, F5 Networks (FFIV) similarly looks reasonable based on current and next year's earning expectations, however the company will need to earn $2 per share in the final quarter of this year to meet expectations ($0.56 per share was the best quarter to date).

   Although these valuations provide a rough overview for the securities, it should be taken as just that. In general analysts have a very poor track record of predicting earnings a couple quarters out, let alone a couple years. Also, the valuations in a couple years should reflect earnings expectations for the following couple years. Over time, as companies mature, one would expect the size of earnings growth to shrink along with P/E multiples. Therefore, many of these companies may find it tough to maintain such impressive growth over the next 3-5 years plus. However, as the "Fast Money" crew and many others have suggested recently, these stocks continue to run up in price and at some point you've got to get on board. Valuations may not matter today, but they will at some point...right?


Disclosure: No Positions in AMZN, PCLN, NFL, BIDU, LVS, CMG, FFIV, CRM or WYNN.