November 25, 2020

3 “Expensive” Stocks That Are Historically Cheap

Whether you’ve been investing for a few months or multiple decades, it’s been a buckle-up-and-hold-on sort of year. We’ve watched as the S&P 500 set records for the fastest bear market decline in history, as well as the quickest rebound to fresh highs from a bear market low. If anything, 2020 has been a reminder that trying to time the market is fruitless.

This wild year for equities could also represent a coming-out party for value stocks. Historically speaking, value stocks outperform growth stocks during periods of economic expansion, which is where the U.S. economy appears headed.

However, this doesn’t mean that investors should ignore stocks that are perceived as expensive. While many pricey stocks will remain so for the foreseeable future, a trio of fundamentally expensive stocks are actually historically cheap, provided you don’t use the price-to-earnings ratio as your sole measure of value.

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Image source: Getty Images.

Amazon

If there’s one well-known company that’s rarely referred to as cheap, it’s e-commerce giant Amazon (NASDAQ:AMZN). This is a company that’s almost always chosen to reinvest its operating cash flow back into its business. As a result, Amazon has never prioritized profitability, which is why its end-of-year price-to-earnings (P/E) ratio over the past five years has averaged 216. Based on traditional fundamental metrics, there’s not one drop of value in these figures.

Attempting to value high-growth companies that reinvest a significant portion of their cash flow by their P/E ratio makes almost no sense. A much better measure of value for Amazon is its operating cash flow. Between 2010 and 2019, Amazon ended every year at a multiple of between 23 and 37 times operating cash flow. However, with $201 per share in operating cash flow expected in 2023, Amazon is currently valued at between 15 and 16 times future cash flow. That’d be historically cheap — about half the midpoint of its average multiple over the past decade.

There’s no question that Amazon’s e-commerce segment draws traffic and has familiarized hundreds of millions of consumers with the brand. Amazon has, after all, signed up more than 150 million Prime members worldwide who are taking advantage of the company’s superior logistics and content offerings.

But it’s not e-commerce or ad-based revenue that’ll drive a near-tripling in operating cash flow between 2019 and 2023. That honor goes to cloud infrastructure segment Amazon Web Services. With the coronavirus disease 2019 (COVID-19) pandemic reshaping the office environment and the retail space, more businesses than ever are leaning on cloud-based networks. AWS provides the building blocks for these predominantly small- and medium-sized businesses. Since cloud margins are many times higher than retail or ad margins, AWS will catapult Amazon’s operating cash flow as it grows into a larger percentage of total sales.

A biotech lab researcher using a dropper to place samples into test trays.

Image source: Getty Images.

Alexion Pharmaceuticals

The biotechnology industry is no stranger to premium valuations. The vast majority of biotech stocks are losing money. Investors typically value these companies based on some multiple of future peak sales potential. It’s not a precise formula, and it can lead to some head-scratching premiums.

Ultrarare disease drug developer Alexion Pharmaceuticals (NASDAQ:ALXN) has a trailing-12-month P/E ratio of 33 as of Oct. 7, and over the past five years has averaged a P/E ratio of 107 and a price-to-cash-flow multiple of 31. But like Amazon, it’s a heck of a lot cheaper than you might realize.

According to Wall Street’s consensus, Alexion is valued at a mere 8 times forecasted earnings per share for 2023 and, more importantly, only 9 times operating cash flow for 2022 (this being the latest consensus estimate available). This blows Alexion’s “expensive” valuation multiples over the past half-decade out of the water and squarely puts this high-growth company in the value column.

A combination of disease focus and innovation keeps the wheels turning at Alexion. As noted, this is an ultrarare disease drug developer. Alexion takes on a lot of risk by targeting indications with very small pools of patients, but the reward is great when it’s successful. There’s typically little to no competition in the indications it targets, and insurers rarely have any recourse to push back against the company’s high list prices.

The second factor is Alexion’s innovation, as seen with the development of Ultomiris. For more than a decade, it’s ridden the coattails of top-selling drug Soliris to big gains. However, Soliris’ patent exclusivity began waning. In an effort to lock in its cash flow for a long time, Alexion developed Ultomiris as a next-generation therapy to replace Soliris. Ultomiris doesn’t need to be administered as often as Soliris, so it’s an upgrade for patients as well as a cash flow growth driver for Alexion.

A Facebook engineer inputting computer code on a laptop.

Image source: Facebook.

Facebook

Social media kingpin Facebook (NASDAQ:FB) is another member of the popular FAANG stocks that few folks would consider cheap. Facebook boasts a trailing-12-month P/E ratio of 32, a five-year average P/E of 42, and a five-year average operating cash flow multiple of almost 24. Not exactly value territory, in the traditional sense of the term.

However, Wall Street is looking ahead, not behind. Facebook, like Amazon and Alexion, reinvests a lot of its operating cash flow into organic growth opportunities and product development. As a result, Facebook’s operating cash flow is expected to hit $23.99 a share by 2023. That would be a multiple of 10.8 times operating cash flow, or less than half of the company’s five-year average multiple to operating cash flow.

Facebook remains the clear go-to for social media advertisers. Facebook ended the June quarter with 2.7 billion monthly active users, as well as 3.14 billion family monthly active users (these family accounts include other owned assets, like Instagram and WhatsApp). There isn’t a social platform anywhere that advertisers can go to where they can have access to more targeted eyeballs. This gives Facebook incredible pricing power on its ads.

What’s even more amazing about the company is that it isn’t even fully monetizing its assets. Facebook currently collects advertising revenue from its namesake Facebook platform and Instagram, but hasn’t yet done much in the way of monetizing Facebook Messenger or WhatsApp. Facebook also has an opportunity to add an abundance of new revenue streams built within its platforms, such as Facebook Pay, or perhaps some form of streaming service down the line.

The point is, Facebook is still in the middle innings of its growth trajectory, and it’s historically cheap by nontraditional fundamental standards.

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