Deciding when to sell a stock can be more difficult than getting your teenage sons to put away their laundry. (Or maybe that’s just my teenage sons.)
As we’ve discussed before, there are plenty of reasons that people hold on to stocks longer than they should. But most agree--at least in theory--that when a stock’s valuation reaches nosebleed levels, it’s time to sell.
One common metric for evaluating whether a stock is undervalued or overvalued is the price/earnings ratio. Mathematically, a P/E ratio is a stock's current price divided by the company's 12-month earnings per share. A forward P/E (which is what we’re using in today’s screen; more on that in a bit) uses a company’s mean EPS estimate for the next fiscal year in the denominator.
A high P/E usually indicates that the market will pay more to obtain the company's earnings because it believes in the firm's ability to increase its earnings. In other words, investors in lofty P/E stocks are willing to pay more for what they expect to be high earnings down the road.
Owning high P/E stocks isn’t necessarily a bad thing: After all, high P/E names may in fact deliver on the heady growth expectations embedded in their prices. However, high P/E stocks can carry price risk, meaning that they can fall especially hard when the market hits a pothole, or if their earnings stories don’t pan out.
While P/E is certainly a widely accepted yardstick for measuring whether a stock is over- or undervalued, our analysts take a different approach: They focus on calculating a stock’s fair value estimate, which represents intrinsic value based on expectations of a company’s future cash flows. If a stock’s price is below that fair value estimate, it’s undervalued in our eyes.
For today’s screen, we wanted to find stocks that were overvalued according to their P/E ratios yet were undervalued according to our metrics. Specifically, we targeted stocks whose forward P/Es were more than twice that of the S&P 500 but whose star ratings were in 4- and 5-star range. (We tossed out extreme uncertainty stocks from the mix, given the difficulty of accurately estimating the future cash flows of such companies.) Thirteen stocks made the cut. These stocks might look like sell candidates given their P/Es, but we’d argue otherwise.
Here’s a closer look at three of the stocks on the list.
BioMarin Pharmaceutical (BMRN)
Economic Moat: Narrow
Moat Trend: Positive
Uncertainty: Medium
We assign BioMarin a narrow Morningstar Economic Moat Rating and a positive Moat Trend Rating, owing to the company’s rare-disease drug portfolio and growing experience in gene therapy. The company’s life-saving therapies may serve only a few thousand patients worldwide, but their six-figure price tags make BioMarin’s marketplace an attractive one, observes sector strategist Karen Andersen.
Despite the stock’s towering P/E, shares are trading about 30% below our fair value estimate as of this writing. The market is underestimating the potential sales for the company’s forthcoming hemophilia A gene therapy valrox and achondroplasia drug vosoritide, argues Andersen. In fact, she suggests that each drug could generate peak sales topping $1 billion.
“BioMarin is amassing a portfolio of genetic-disease therapeutics, making historical comparisons with Genzyme (now Sanofi) difficult to avoid,” Andersen explains. “Commercialization and research and development expenses have kept BioMarin in the red, but we're confident in the profit-generating power of its rare-disease treatments … With a deep in-house pipeline and the ability to supplement growth with strategic acquisitions, BioMarin is in a strong position.”
Amazon.com (AMZN)
Economic Moat: Wide
Moat Trend: Stable
Uncertainty: High
The online retailer has become our go-to example of a stock that looks overvalued by many standard metrics yet is undervalued according to ours.
“In Amazon's case, we do not believe traditional price/earnings and enterprise value/EBITDA metrics are meaningful, given the impact that technology, content, and infrastructure investments are expected to have on near-term margins,” explains sector strategist R.J. Hottovy. “Still, we believe Amazon warrants a premium valuation based on its wide economic moat, meaningful avenues for growth, and longer-term margin expansion potential.”
The firm’s moat--one of the widest in the consumer sector--stems from its operational efficiency, network effect, and brand intangible assets; Hottovy says that Amazon’s sustainable competitive advantages are unmatched and should yield additional market-share gains in the years to come. Arguably the most disruptive force in retail over the past several decades, Amazon is likely to continue to reshape retail, digital media, enterprise software, and other categories for years to come, he concludes. Shares are trading 17% below our fair value estimate today.
Tyler Technologies (TYL)
Economic Moat: Wide
Moat Trend: Stable
Uncertainty: Medium
Tyler Technologies provides a suite of software solutions that help federal, state, and local governments run more efficiently. We assign the firm a wide economic moat, thanks in large part to high customer switching costs. After all, changing software platforms can be time consuming and expensive, especially at the time of implementation, points out analyst Dan Romanoff. Further, there are indirect costs, including lost productivity as employees ramp up on a new system. Most important, says Romanoff, is the operational risk, including loss of data, project execution, and operational disruption. We therefore expect customer retention for Tyler Technology's products to be extremely high.
“We view Tyler Technologies as the clear leader in a slow-moving and underserved niche market of government operational software,” he explains. “We believe there is a decade-long runway for 10%-plus growth at Tyler, given the need to modernize local governments’ legacy enterprise resource planning systems and the firm’s strong position in this market.”
Despite its heady P/E, Tyler Technologies is undervalued, trading about 14% below our $247 fair value estimate.
