Recently I heard a TV stock pundit note that ever since Exxon Mobil (XOM) was booted from the Dow Jones Industrial Average, its share price is up over 100%.
Meanwhile, the hot tech-sector stock that replaced Exxon is down 21%. This story indicates how often investors don’t take valuation into their investment decision process.
On August 31, 2020, “old economy” stock Exxon Mobil was replaced by Salesforce (CRM), a tech company that helps its customers manage all aspects of their business. Salesforce has a strong history of revenue and profit growth, so why has the share price fallen by 21% over the last 18 months, and 33% since the stock peaked in November 2020?
I say it’s because eventually, valuation always wins.
There are many ways to evaluate the valuation of a stock. Widely used is the price-to-earnings (P/E) ratio. You calculate P/E by dividing the share price by the annual earnings per share. Every financial website shows the P/E of individual stocks.
In general, stocks with faster-growing earnings will carry higher P/Es, as investors are willing to pay more for growing profits. Let’s look at the P/Es for Exxon and Salesforce when they swapped DJIA membership.
Because of the pandemic-triggered energy price crash, 2020 was a money-losing year for Exxon Mobil. Using the 2019 EPS of $2.25 per share and the August 31, 2020, share price of $39.94, Exxon had a P/E of 17.8 at that time.
Salesforce reported EPS of $3.00 per share in 2020, against an August 31 share price of $272.65. Those numbers give a P/E of 90. Salesforce was valued at five times Exxon’s value, a very high bar to live up to.
Investors are often willing to pay any price for emerging technology, high revenue growth, or hot theme stocks. Investors ignore traditional valuation metrics when they are trying to grab shares of the next big thing… but that tactic rarely works out well.
Eventually, valuations come back to earth, which means share prices will decline, even if profits grow. When profit growth slows, it gets even worse, as we saw last week when Meta (FB)’s reported profits showed earnings had stopped growing.
The day after earnings, Meta dropped by 25%!
Value investing can be viewed as the opposite of growth investing. Growth investors often pay too much for future earnings and then end up disappointed with share price returns.
Value investors look for stocks trading at a discount to earnings or growth valuation. Value investing takes patience but is more likely to pay off for the long-term investor.
This article originally appeared at Investors Alley.