Invest in Narratives, Not Financial Ratios

Invest in Narratives, Not Financial Ratios

It must be the end of the year, because experts are on television making their case why high flying some stocks will surely plummet in 2021.

This month Aswath Damodaran, a distinguished professor at New York University called Peloton Interactive, Inc. (Nasdaq: PTON) and Zoom Video Communications (Nasdaq: ZM) investors lazy and said Tesla, Inc. (Nasdaq: TSLA) shares are priced for a transition that no company has ever successfully pulled off.

I believe the professor misunderstands why the shares have been so strong.

In fairness, Professor Damodaran’s background is finance. He’s valuing the businesses on the basis of cash flows and profit margins.

Financial ratios are important starting points, but they have never solely determined stock prices. Big price changes are more about prevailing narratives than some set of numbers that show up on a 10-K filing.

Peloton and Zoom investors were not being lazy when they sought businesses that would benefit from the pandemic. They understood the depth of the larger digital trend and the likelihood that several quarters of strong sales would drive price momentum higher.

As for Tesla, Damodaran claims shares of the electric vehicle maker is being priced like a software company that will earn $500 billion in sales with profit margins up to 25%. This would be a business three times larger than Microsoft Corp. (Nasdaq: MSFT) and every bit as profitable.

Except that is not how Tesla is being valued.

Investors are betting the Palo Alto, Calif.-based company will maintain its lead in a global EV market that is expected to increase from 3% of all automobiles sold to as much as 28% by 2030, according to a forecast from BloombergNEF.

This narrative advances every time competing automakers ramp up their plans for electrification, or Tesla managers exhibit technology leadership. Given that the company regularly updates the fleet with over-the-air software goodies, this process is ongoing.

It is not crazy that these powerful narratives can drive stock prices for extended periods. The last three transformative technologies; personal computing, network computing and digital transformation gave us Dell Technologies, Inc. (Nasdaq: DELL), Microsoft, Cisco Systems, Inc. (Nasdaq: CSCO), (Nasdaq: AMZN) … and now Tesla.

These category leaders went on to rally for many years.

From its initial public offering June 23, 1988 through Dec. 31, 1999, Dell shares advanced 50,776%. A $5,000 investment turned into $2,538,880. Investors earned fortunes staying with a fast-growing business at the vanguard of an important new category.

It’s easy to be skeptical about market dynamics and share prices that rise fantastically. It’s even easier to sell too early, then argue everyone else is wrong.

For the record, Damodaran admits that he sold his Tesla shares at $120. The current share price is $661 and rising. He also says Peloton and Zoom became overpriced early on during the pandemic. Assuming that means May, the share prices would have been pegged at $32 and $144 respectively. That’s 500% and 250% lower, respectively.

The point is not to disparage Damodaran. Setting public price targets is difficult.

The takeaway should be that the market sets prices, not a set of magic financial ratios. Believing otherwise is a fundamental misunderstanding of the processes.

And I’m not arguing Peloton, Zoom and Tesla are to digital transformation what Dell and Microsoft became to the personal computing era.

Still, connected home gyms, virtual meetings and cars that are more software than engines, transmissions and driveshafts are transformative … in a similar way computers were. It’s easy to see how these narratives could last quite a while longer.

The bottom line is that investors need to be aware that narratives drive stock prices. Staying with a strong investment story is a better longer-term strategy than watching financial ratios.

Best wishes,

Jon D. Markman

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