Valuation isn’t Always About the Numbers

Every day, asset managers make decisions concerning equities whose valuations can be difficult to judge.

Certainly, relying on traditional quantitative metrics such as P/E ratio or earnings estimates is one way to determine when to hold or sell certain positions. But depending too heavily on such metrics has many shortcomings.

Countless companies over the years have defied expectations – both for better and worse – based on P/E ratios, which are retroactive, or projected earnings, which can be unreliable given how quickly consumer trends can turn.

As an example, look no further than Abercrombie & Fitch, which not too long ago enjoyed strong brand loyalty and robust revenue. Today, the company is in a state of flux, having seen its sales numbers within its core, 18-22 year-old demographic plunge over the last two quarters, sparking a 33 percent drop in its stock price since the beginning of August.

On the other side of the spectrum is Best Buy. The company has struggled in recent years amid sagging sales and greater e-commerce activity among consumers. Yet, through the first ten months of 2013, Best Buy has jumped more than 250 percent, thanks to internal efforts to cut costs and revamped in-store layouts, as well as an increased willingness to directly engage its online-only competitors, most notably Amazon.

At this time last year, it would have been difficult for anyone to correctly forecast the unexpected turn these companies have taken. It underscores why asset managers should take a broad, comprehensive approach when making hold and sell decisions for clients: Continue to rely on raw, quantitative data but also take into consideration a wide array of qualitative factors that often get overlooked.

To illustrate this point, let’s take a look at Tesla. In absolute terms, the stock is perhaps overvalued, especially relative to other car companies. But if you look at Tesla as a tech firm – which is reasonable, since it has far more in common with Apple than Ford – a different picture begins to emerge. Its current valuation is actually fairly cheap by tech standards, trading at roughly eight times revenue. (By comparison, following its IPO earlier this month, Twitter traded at more than 20 times its 2014 projected revenues, according to Bloomberg).

But there are other, more qualitative reasons to like Tesla, as well. Those include:

• No real competition in the high-end electric car market;
• A favorable tax regimen in U.S. and international markets;
• It compares favorably to ultra-luxury sports cars but at a cheaper price;
• A management team that has demonstrated the ability to execute their business plan;
• Strong positive brand awareness.

While disappointing third quarter earnings and a recent media storm concerning a few isolated in-car fires have soured many investors on Tesla, based on the above, we see room for continued growth and are optimistic about the company’s future.

We took a similar approach with respect Microsoft in 2000 but made an entirely different decision. When Steve Ballmer assumed the role of CEO, the company had built a dominant position within its market and its stock was taking off. Moreover, it looked well positioned to diversify its product offerings and appeared poised to further grow its cash flow and revenues.

But beneath the surface, there was cause for alarm. Based on the following factors, we moved on from Microsoft, just as many others were getting in:

• Its brand was lagging across multiple lines of business and many of its product initiatives had failed;
• While Ballmer excelled as a sales executive, he had neither an entrepreneurial background nor the strategic creative vision to propel the company forward;
• The workforce was bloated and unfocused.
• Outsized dividend payments and stock awards – instead of options – were a tacit admission that the company’s runway for growth had become limited.

Though we are bullish on the video game industry in general and the release of the Xbox One game console in particular, Microsoft continues to be fraught with problems – including its disappointing foray into the smart phone and tablet market. And while the Xbox has been hugely successful, it does not make the rest of the company more attractive. To this day, we have significant concerns about its growth prospects, and have steered clear of the company as a result.

By focusing on quantitative valuation measures, many asset managers miss the real story with companies and make reactive decisions. In both the Tesla and Microsoft cases, the qualitative measures we used to make our decisions would have been difficult – if not impossible – to quantify.

No asset manager will ever bat 1.000, but taking a 360-degree, in-depth view into companies will always help add a few points to the batting average.


Ross Gerber is CEO and president of Santa Monica, Calif-based Gerber Kawasaki (www.gerberkawasaki.com), an independent investment advisory and wealth management firm with approximately $200 million in assets under advisement. Gerber Kawasaki clients and employees may own positions in various companies mentioned in the article. Readers should not construe this article as a research report and should not buy anything without doing their own research.