After a rough couple of months, momentum stocks like Facebook Inc (NASDAQ:FB) and Tesla Motors Inc (NASDAQ:TSLA) have stabilized, but many argue that tech stocks are still overvalued despite recent corrections. While the number of tech stocks with high price relative to last twelve months sales (LTMS) is above average, it’s set against the backdrop of a market that isn’t that cheap in general.
“2014 has been characterized by an investor style shift from higher valuation, high growth stocks towards stocks with more reasonable valuations,” writes Bernstein Research analyst Toni Sacconaghi Jr, “Despite the pullback, there are still an above average number of tech stocks trading at greater than 8x LTM sales.”
PE doesn’t tell the whole story for tech stocks
When you rank tech stocks by price to forward earnings and other similar metrics, the top and bottom of the list tends to outperform the middle. Outperformance of low PE stocks is easy to understand, plenty of investors like to buy cheap stocks regardless of what sector they’re in, but the high PE outperformance is more distinct. Unlike a retail chain or a logistics firm, tech companies with essentially no revenue can often tell a different growth story based on metrics like eyeballs and daily active users that get investors’ attention.
It’s tempting to conclude that some tech investors are overly driven by sentiment and move on, but valuation methods aren’t equally useful across the board and Sacconaghi argues that P/LTMS gives a better picture of how overpriced the tech sector is relative to the rest of the market. Tech stocks with P/LTMS above 8x underperform both the market and the tech sector on any time scale from 1 month to 2 years, while stocks with 10x P/LTMS do worse and 15x worse yet. Since the whole point is to help us figure out where to invest, this is the behavior that you want a valuation metric to exhibit.
Non-tech stocks also overvalued according to P/LTMS
Out of the largest 224 tech stocks by market cap there are currently 25 with P/LTMS above 8x, compared to a post-2002 average of 16, and a high of 40. For comparison, of the 991 non-tech, non-financial companies in the same sample (top 1500 by market cap) there are 40 stocks trading above 8x compared to an average of 31. By this measure, the tech sector is the most overvalued sector (followed fairly closely by healthcare products) in a generally overvalued market. Both have come down since March, but if sales don’t pick up soon they have more room to fall.