In this educational video, Brian Dress, Director of Research at Left Brain Investment Research, explains what valuation means and why common market multiples can be misleading. He begins with an Oscar Wilde quote to illustrate the difference between price and true value, arguing that market prices often reflect irrational behavior and therefore are a poor proxy for intrinsic worth. Dress reviews two widely used valuation ratios—price‑to‑earnings (PE) and price‑to‑sales (P/S)—detailing how they are calculated, the distinction between trailing and forward versions, and the contexts in which each is appropriate. He notes that PE is most useful for mature, profitable companies, while P/S, especially forward P/S, is better suited for early‑stage, high‑growth firms that may not yet be profitable. A case study of Zoom Video is presented: despite a forward P/S of over 30×, the company’s 120% annual revenue growth justified the premium, and the stock later rose fivefold. Dress emphasizes that valuation must be interpreted with broader context—growth trajectories, competitive positioning, profitability trends, and management quality—rather than relying on simplistic heuristics like “low valuation = buy, high valuation = sell.” He concludes that deep analyst research provides the necessary nuance for making informed investment decisions and invites viewers to subscribe for more content.
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Hello and welcome to Fundamentals of Investing from Left Brain Investment Research. Today we answer, what is valuation? I'm Brian Dress, Director of Research here at Left Brain Investment Research. In this series, we shed light on key industry terms investors need to know. In this episode, we answer, what is valuation? There's an old quote from author Oscar Wilde, the cynic knows the price of everything and the value of nothing. We think this is a great illustration of the phenomenon we observe in the stock market on an ongoing basis, which we view as the source of opportunity in markets. In financial media, valuation multiples like PE are thrown around liberally. The valuation metrics used by Wall Street are an attempt to establish the worth of a given stock or security, which is an important goal. But can you see the problem here? These valuation metrics rely on share price, which tells us little about the long-term value of a stock. As anyone with the slightest experience in this industry understands, that market participants aren't always rational, which means that market price is a terrible way to assess value. With that understanding, we can reach the conclusion that conventional valuation metrics are limited in their usefulness to investors. Let's talk more specifically about two of the most used valuation ratios often mentioned. The first of these metrics that we'll cover is price-to-earnings. PE is a simple ratio computed by dividing a company's market capitalization by its net income or profit. If based on last year's earnings, we call it trailing PE. If the ratio is based on next year's earnings, we say forward PE. Consider a company with market cap of $10 billion and yearly earnings of $1 billion. We would compute the PE ratio of that business to be 10x. For growth investors like Left Brain, it is useful to compare PEs of companies in the same sector as some basis for comparison. However, for the most part, the use of PE only makes sense for mature and profitable companies. Let's move over to the valuation metric that we consider more closely at Left Brain: price-to-sales. Since many of the companies we follow are in early stages, they fall short of profitability, so PE would not be meaningful. Again, price-to-sales can be either trailing or forward. We prefer to evaluate the forward ratio, as what's happening in the future is more illustrative of upcoming stock performance than what has happened in the past. Though many market participants see a price-to-sales ratio in excess of 10x and decide a stock is overvalued, We found this isn't a given for this class of stocks. In late 2019, one of our analysts failed to recommend Zoom Video on valuation concerns when it had a price-to-sales ratio of over 30x, which conventional wisdom says is far overvalued. Despite a positive read on the rest of the company's characteristics, we passed on the stock. Zoom stock has increased fivefold in the time since. So what was happening with Zoom? The most obvious reason for a stock to carry a premium valuation is a strong revenue growth trajectory. When we passed on Zoom first time around, it traded at 30x price-to-forward sales, which seemed ridiculous at the time. However, context is key. The company was growing revenues at nearly 120% annually. In retrospect, the growth rate more than explained the premium valuation. Other characteristics can explain a premium valuation, including lack of competition, higher increasing profitability, or a high-quality management team. These are concepts we try to identify when we analyze investments that cross our desks. The key point in using valuation as an investment indicator is to look deeper rather than falling back on simple-minded thinking like, "A low valuation means buy and a high valuation means sell." This thinking can lead to investments in value stocks that underperform and missed opportunities from high-performance growth stocks. That's why the most important part of our decision process come from our analyst reports, which provide a deeper context for numbers like valuation ratios. We hope this helps you understand more about the impact of valuation metrics on investment strategies. One of the most misunderstood and misused concepts in the investment business. For more educational videos like these, along with individual stock and bond reports, click the subscribe button below. You get the latest from LBIR and have the chance to become a part of our growing community of left-brainers who experience the informed decisions and independent thought that powers our search for more profitable investment opportunities. Learn more at our website, www.leftbrainir.com. This is Brian Drez of Left Brain Investment Research for Fundamentals of Investing. Thank you, and we'll see you again next time.
