After a bit of a hiatus, we continue our blog series: Market Musings, Volume 3, Edition 1, giving our (hopefully not too random) thoughts on recent goings-on in the markets. Today, we present "Dell, Tesla, Netflix and the Rule of 2X".
Back in 1999, Dell Computer Company was the toast of the stock market, with shares exploding upwards during the Tech Bubble. Below we show the growth in Dell's stock price, adjusted for splits, from its 1989 IPO until it was taken private in 2013 (see source data here):
The torrid 50X appreciation in the stock from the beginning of 1996 to the end of 1999, which resulted in a market cap at the height of the bubble of ~$120B, fascinates. Obviously in late 1999 investors were pricing in massive profits for Dell over the ensuing decade or two. As of Christmas 1999, only 29 companies in the world had a higher market cap than this hyper-growth computer manufacturer:
Interestingly, Dell ended up delivering huge profits by the time it was taken private 14 years later, namely ~$30B over that span. Unfortunately, this amount of aggregate net income was a mere 1/4th of the company's market cap back in its halcyon days. Predictably, on a split-adjusted basis the stock fell almost 75% over that period despite the fact that the company was immensely profitable (just not as profitable as 1999's investors hoped). By the time founder Michael Dell and P/E firm Silver Lake bought public shareholders out, Dell's once massive equity capitalization had shrunk to a much more reasonable $23B.
This brings us to a simple rule of thumb for sensible investing in the stock market: Never buy a company unless you rationally believe that said company will deliver aggregate profits over the ensuing decade equal to at least twice its then-current market cap (the "Rule of 2X"). We know from the Rule of 72 that if an investor doubles his or her money over a decade, said investor will make a compounded return of 7.2% per year. Thus, if we logically conclude that a company can deliver profits equal to double it current market cap over the ensuing 10 years, an investor buying shares at such a valuation should earn a return at least equal to 7.2% (and probably 3-5% above that bogey, since they will still own the company at the end of the decade). Thus, if (for example) the market cap of a company is $10B, a rational investor (i.e., one not using "pie-in-the-sky" assumptions regarding future growth, lack of competition, the vagaries of chance, etc.) should buy if prospects reasonably appear favorable for the company to deliver $20B in profits over the following 10 years; moreover, the company probably should have earned at least 5% of this amount (or $1B) in the fiscal year immediately preceding the purchase.
Now consider two current market darlings: Netflix (NFLX) and Tesla (TSLA). In order for an investor to rationally purchase NFLX and TSLA at their current market valuations, one would need (per our Rule of 2X) to pencil in (A) $312B in profits for NFLX for the period from 2019-2028 and (B) $102B in profits for TSLA for the period from 2019-2028. If one cannot reasonably do this, one should not expect outstanding (10% or more annually) investment returns from these two stocks going forward. And if one cannot reasonably pencil in anything remotely close to such profit figures, then the investment will likely resemble Dell's 1999-2013 performance outlined above (down massively).
So, is it reasonable to assume that NFLX will deliver $312B in profits over the next decade? Here is NFLX's trailing 5-year profitability track record (source):
Likewise, is it reasonable to assume that TSLA will deliver $102B in profits over the next decade? Here is TSLA's trailing 5-year profitability track record: