The fall in price of a share of a company’s stock of 50% from its previous high, does not make it now worth twice as much as the current price. It doesn’t even make it worth any more than its present price if that amount.
The unmanipulated price of a stock in a public market is the result of the aggregate perspective of investors regarding future EPS which have been honestly calculated, or the price likely to be paid for the company’s shares in an acquisition of the company. The reputation of those sponsoring the company or otherwise involved will also impact the valuation.
If the earnings are expected to increase significantly, the stock may be very attractive, as would also be the case if the company were to be acquired either for a possible buyer’s strategic reasons or due to the current price being below the book or other attainable value of the company. A stock selling at a very low P/E, due to high EPS, can be highly attractive if future EPS levels are only modestly less than the recent EPS.
An asset is worth the relative value of that which it produces. The stock of an unprofitable company is unlikely to increase in value, unless the physical assets of the company have a greater market value than their book price reflected in the price of the stock. However, there are rare but increasing instances of companies having relatively poor EPS performance doing OK in the market. I believe that this phenomenon is due to the large amounts of capital which need employment, and a hope-based belief that improvement will occur.
The market valuations currently being applied to early-stage, high tech companies of significant multiples of revenues are, in my opinion, likely to be viewed in the future as an irresponsible use of capital, mostly by those playing with other people’s money. It is also a reflection of the vast amount of money seeking high returns from an expected application of the Greater Fool theory of investment. Some of these companies will obviously ultimately develop good, high profit margin, businesses. There are also some of the companies which will be acquired on advantageous terms. However, I believe that stock market valuations are eventually going to be based on the basics of EPS growth, reasonable P/E’s, and dividends. To profit by owning a stock selling at lofty valuation levels investors must be accurate in their prediction of wonderful future events. Unfortunately, most predictions are the product of “the wish being the parent of the thought”.
As many early-stage companies can generate revenues, while struggling with developing sustainable profits, investors are better served by owning a percentage of the company’s defined revenues, than the company. For this reason, we champion the use of revenue royalties, specifically structured for pre-revenue companies, which also enable company founders to avoid equity dilution. Of course, we also believe that royalties are the better way for both business founders and investors to finance most privately owned companies.
Arthur Lipper, Chairman arthurlipper@gmail.com
British Far East Holdings Ltd.