Stories to Watch: Stock Market Arithmetic
Nicole Gelinas on the latest tech boom; The WSJ on Instacart's planned IPO; Aswath Damodaran on Netflix and Disney; Alan Pentz on the Bear Steepener
Note: For the most part, this post was written before the latest market dip. I wrote the Bear Steepener section September 26, and the other items several days before that.
As Grant recalls, in 2002, after the dot-com collapse, Scott McNealy, then-CEO of computer giant Sun Microsystems, lamented that the tech bubble had expanded so much that investors thought it made sense to buy his company’s stock at ten times its revenues. For such a valuation to pay off for investors, McNealy observed, “I have to pay 100 percent of revenues for 10 straight years [to investors] in dividends,” assuming no employee salaries, no rent costs, and no tax payments. “Do you realize how ridiculous those basic assumptions are?” This May, however, Grant notes, NVIDIA, one of today’s tech darlings, traded at nearly 40 times its revenues.
Grant is James Grant, a financial journalist who is perpetually warning about debt. The ratio of a stock price to its revenues is equal to the price/earnings ratio times the ratio of earnings to revenues. The latter is the profit margin.
For a typical mature company, the P/E ratio might be 15, and the profit margin might be .04, so that the ratio of price to revenues would be less than 1. Of course, people think that NVIDIA is going to enjoy high profit margins, because demand will be high with very little competition. And they think it will grow a lot, so it should enjoy a high P/E ratio. A combination of a P/E ratio of 100 and a profit margin of 40 percent would get you to 40 for a price/revenue ratio. But that seems like a stretch.
[Instacart] generated $242 million in profit for the first six months of the year compared with a $74 million net loss a year earlier.
Instacart’s revenue increased by about 31% to $1.5 billion
It is hoping to go public for $9 billion. That would be three times annual revenue of $3 billion. The P/E ratio would be around 19, and the profit margin would be about .16. The retail food business is highly competitive, and a 16 percent profit margin would be amazing if they could keep it up. But Moses Sternstein would tell you that the profit potential is in advertising, where the margin could be much higher. Anyway, two years ago Instacart thought it could go public at a value 4 times what it can get today. Be glad that you didn’t but any of its stock at that price.
I wonder if the analysts who see growth in grocery sales talk to the analysts who see growth in restaurant chains. And I wonder if either of those analysts talk to the analysts who see growth in appetite-suppressing drugs.
I wonder if the analysts who see growth in advertising revenues at companies like Instacart talk to analysts who see growth in advertising revenues at Meta and Google. I wonder if anyone has calculated where the implied asymptote is for the share of the economy devoted to advertising.
Aswath Damodaran writes,
Between 2013 and September 2023, Netflix gained $174 billion in market capitalization, posting an annual return of 24.5% a year. During the same period, Comcast, Disney and Warner saw their market capitalizations stagnate, in a period when the market was up strongly, effectively translating into a lost decade of returns to shareholders. Live Nation, the fifth largest company in the group in September 2023, barely registered in the rankings in 2013, but has risen 17.19% a year to reach its current standing.
…Put simply, the market seems to be pricing in the presumption that Netflix will continue to get content costs under control, while still delivering growth similar to what it has delivered in the past, while it is pricing Disney for low growth and margins that will fall short of their historic norms. I agree that Disney is a mess, right now, but I do believe that at current pricing, the odds favor me more with Disney than Netflix, but that is just me!
The bear case concerning Disney is that it suffers from internal turmoil and challenges with adapting to streaming. The bear case concerning Netflix is that the streaming market may not turn out to scale up and be highly profitable.
You know the trope of people going to Hollywood hoping to become stars and ending up waiting on tables. I wonder if a lot of entertainment companies hoping to become stars will end up waiting on tables.
Before the recession happens, the curve starts to normalize in what is called a “Bear Steepening.” This is when longer term rates start rising faster than short term rates.
Some people read the bond yield curve as if it were tea leaves. I don’t. I would just interpret a Bear Steepening in a nearly tautological way: if long term rates are rising faster than short term rates, then investors have shifted their probability distribution of future interest rates upward.
Investor expectations could be wrong, of course. But if they are right, then it should be more of an inflation warning than a recession signal. Not that we couldn’t have both.
Higher interest rates mean higher nominal borrowing costs. If inflation picks up, you are paying back loans in cheaper dollars, which in principle makes borrowing a reasonable deal.
In practice, I expect borrowing in the private sector to slack off in response to higher interest rates. With the public sector, it will be the opposite. The U.S. Treasury will have to print more T-bills to pay the higher interest rate. That will fatten up people’s money market accounts, injecting more artificial wealth into the economy.
I have not been following the government shutdown debates. I assume that the Republicans will form a circular firing squad, and fiscal policy will remain on its unsustainable course.
Those of you who subscribe to the WaPo can read an op-ed advocating a fiscal responsibility commission. I’m all for it, but, well…have a nice giggle.
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"I wonder if the analysts who see growth in grocery sales talk to the analysts who see growth in restaurant chains. And I wonder if either of those analysts talk to the analysts who see growth in appetite-suppressing drugs."
I suppose it's possible for prices to change enough and in such a way so that all three grow at the same time. But I'm pretty sure we're not at some turning point for American obesity rates and calorie consumption; I'd sooner bet on "Peace in the Mideast."
We already have a large portfolio of effective anorectic drugs that, if people would use them at the prescribed doses and in the cyclical manner meant to attenuate the build up of tolerance, they would be 'safe' too. And a lot o people would use them that way, per their doctor's orders, and lose a lot weight and keep it off.
But the trouble is that a large number of people wouldn't, because all these drugs that really work also make them feel really good, such that the "potential for recreational abuse" is too high for them.
Which is why all the best anorectics are banned or under controls extreme enough to make mass weight loss unlikely.
My impression is that this is because most powerful anorectics stimulate chubby people into states and neurotransmitter balances that are physiologically normal for naturally skinny and energetic people, and naturally skinny and energetic people act in a kind of manic way like they are high on life. And to chubby people, when they feel that way, "high on life" is just "high", addictively so. And of course, with higher doses, they can push that high much, much higher. And naturally, a lot of them are going to do just that.
Any new drug that doesn't make chubby people feel like skinny people isn't going to work in the long term to make them stay skinny. The effect will be minor, it will wear off, or there will be side effects like nausea or digestive issues severe enough to make people quit.
More concisely, "If it really works, it will be abused. And if it won't be abused, it won't really work."
Disney: lacks an unclear biz plan of which investors can value; so for the present investors have to go through a variety of scenarios that management might implement. However, one can look at its current cash flow and say what they are willing to pay for it until more clarity comes out regarding a biz plan. For now, I would suggest DIS is probably a reasonable investment .
NVDA might be overpriced, but if so the question is by how much if at all? Does the market price reflect an over pay of say 2 years future cash flows or far more than that? Stock prices are determined by the interaction of supply and demand which will have emotional aspects to it. The price of NVDA has come down and were it to come down to say 400 or a bit less it would represent a good buying opportunity.
Pricing the growth curve for companies that have not reached stabilized growth is always a challenge and there will be some using this or that metric to suggest the market price may be too high and others who obviously see lots of growth ahead; but that is what markets are all about anyone can or should be able to price a stabilized growing bond like company's stock.
Lastly, values will change as interest rates move up or down, but in many cases emotions of investors may take the price of a stock up too much or down too much; but more importantly with regard to the reasonableness of repricing is the extent to which interest rate changes affect drivers of growth such as revenues and operating margins.