Maybe the FAANG hasn’t lost its bite
FAANG has been dominating for almost a decade since our last bull market took off. For those who don’t know, FAANG stands for Facebook, Apple, Amazon, Netflix and Google. These giants have taken advantage of expanding their businesses in our continuously rising bull market. With Apple recently becoming the first $1 trillion-dollar US company and Facebook losing $120 billion in market value, it is important to know how to adequately value these companies and be ready with a shopping list of potential candidates for purchase in case of a significant pullback or correction.
But how exactly do we value these companies? Normal convention has been to use the P/E ratio. This ratio shows how many more times you’re willing to pay for a company’s stock over their earnings. But is this the proper way to value these companies? We say no. These companies are very capital intensive which makes cash flow more meaningful to fund further growth. We have to ask ourselves, do these companies have enough cash to reinvest in the business to take advantage of increased opportunities? We say yes, and this is done with cash flow. Cash flow per share (P/CF) is another metric that shows how richly the firm is valued by how much cash flow they bring relative to their peers or benchmark. CFPS is supposed to increase with all of these companies (except Netflix, since they are using almost all their cash to reinvest back into the company) creating a downward pressure on the Price-to-Cash Flow ratio and increasing the attractiveness of these companies. With more cash flow, these firms have the ability to expand existing product lines, test new features on existing product lines, and potentially acquire complementary businesses.
Valuing these firms and others through cash flow analysis has become increasingly important. We have already discussed what cash can enable a firm to do, but it also allows the firm to pay down debt. Speaking of debt, let’s talk on this as it relates to cash. Firms pay interest on their debt with cash. Given the importance on looking at cash flow, we can use the cash flow to debt ratio to get a better understanding of the sustainability of the firm. We would really like to see a high ratio here to drive home the fact these firms are solvent and can handle their debt burden. It’s also important to look at the unique characteristics of each individual firm (credit ratings, interest obligations, and the amount of debt that will mature during periods of rising interest rates etc.) to understand exactly how “in trouble” they would be when hit with difficult times. Doing fundamental research in these areas has become increasingly important to truly understand FAANG companies true value.
Even though most of the forecasts for these companies are estimating great cash flow (according to Wall Street analysts), it is important to review these estimates. If we have a recession, these companies may need to cover their debt with cash sidelined in short-term investments. Reviewing your portfolio to determine a list of technology stock candidates to sell, as well as purchase, would highly be within your best interest.
Sources
Rogers, T. N., & Ross, K. (2018, July 29). Don't Let Facebook's Meltdown Make You Hate All FAANG Stocks. Retrieved August 5, 2018, from https://www.thestreet.com/opinion/do-not-let-facebook-meltdown-make-you-hate-all-faang-stocks-14665471
Divine, J. (2018, July 16). Netflix Stock Plunges on Subscriber Whiff. Retrieved August 5, 2018, from https://money.usnews.com/investing/stock-market-news/articles/2018-07-16/netflix-inc-nflx-stock
Williams, S. (n.d.). FANG Stocks Overvalued? Actually, A Majority May Be Cheaper Than Ever.
