Does It Make Sense To Buy FAANG Stocks Now?

June 23, 2017

Does It Make Sense To Buy FAANG Stocks Now?

  • With the exception of AAPL, all FAANG stocks have beaten the S&P 500 in the last 5 years.
  • By using Graham’s growth stock formula, I’ve determined the real value of FAANG stocks in order to see whether they are still a good investment.
  • Surprise, surprise, only one stock is overvalued, while some are still bargains.

Introduction

FAANG stocks—Facebook (NASDAQ: FB), Apple (NASDAQ: AAPL), Amazon (NASDAQ: AMZN), Netflix (NASDAQ: NFLX), and Alphabet, i.e. Google (Nasdaq: GOOG, GOOGL)—have been the clear drivers of the current bull market. And all but AAPL have significantly outperformed the S&P 500 index.

The S&P 500 index is up 78% in the last 5 years, AAPL 73%, GOOG 228%, AMZN 334%, FB 389%, and NFLX a whopping 1,454%.


Figure 1: FAANG stock performance in the last 5 years. Source: Yahoo Finance.

The performance is really remarkable and besides riding the last AAPL upward trend, I must say I didn’t invest in any of the above companies. My bad. I didn’t invest in these companies because I always considered them too risky as I didn’t understand the digital moat these companies have been building in the last decade or so. However, a wise investor should always assess their mistakes, even those of omission, and see whether something has changed, what could be expected in the future, and what the risk reward puzzle is at the moment, despite the huge price appreciation the stock have enjoyed.

In today’s article, I’ll analyze whether FAANG stocks could still be an interesting investment, especially now that Goldman Sachs has scared the market because it reported that FAANG stocks will do well over time but will also be very volatile.

Valuations & Growth

The rule of thumb, from Benjamin Graham’s book Security Analysis, is that a growth stock should be fairly valued using the following formula:

V = EPS x (8.5 +2g)

Where V stands for value, EPS for earnings per share, 8.5 for a healthy P/E ratio, and 2g means twice the growth rate.

Using the above formula and by taking the average 2-year earnings growth rate, I’ve come to the following results:


Figure 2: FAANG stocks through Benjamin Graham’s lenses. Source: Author’s calculation.

(I’ve used only two years of earnings growth because the goal of FAANG stocks was first to gain market share, and only then to make profit, therefore, 5 or 10-year profit growth would have skewed the picture.)

To my surprise, only NFLX seems overvalued while GOOG and AMZN are relatively fairly valued, and AAPL and FB are still a bargain.

Now, should one do much more due diligence than the above rule of thumb, or not? Perhaps investing should be kept simple.

So if you want to keep it simple, stop reading here. If you like to complicate things a bit, then feel free to continue.

Future Growth Analysis

In order to determine whether the above analysis is appropriate, we need to estimate future growth. If future earnings growth matches the past two years growth, then the above calculations will really hold.

Analysts expect FB’s earnings growth to be less than the above 78% and around 25% for the next five years on average. AAPL’s 5-year expected earnings growth rate is at 10%, AMZN’s at 27.52%, NFLX’s at 23.75%, and GOOG’s at 16.66%.


Figure 3: Analysts earnings forecasts for GOOG in the next 5 years. Source: Nasdaq.

By putting the forecasted earnings growth rates into Graham’s model, FB becomes less undervalued, AAPL is the most undervalued, AMZN and NFLX are overvalued, while GOOG is almost fairly valued.


Figure 4: FAANG stocks through Benjamin Graham’s lenses and future expected growth rates. Source: Author’s calculation.

Conclusion

As always with growth stocks, the return on investment only depends on future growth. The trouble is that a growth expectation miss has a terrible effect on the stock. Just look at what happened to AAPL two years ago when it went from $130 to $90 very quickly.

However, in the digital advertising world, the moat that GOOG and FB have is incredible as the two companies receive $0.77 of every dollar spent on advertising. As long as the situation remains as is, both can be considered bargains.

How long will the situation remain like this? Well, that’s the million-dollar question that I simply don’t know the answer to. If knew the answer, I would have invested in all of the FAANG stocks in each of the past 15 years that I have been following what has been going on. But, as I don’t know the answer to the most important question, I’ll again let these investments pass me by, simply because they don’t fall into my risk reward spectrum. I prefer stocks with the same potential rewards coming from future growth rates at much less risk.

If you can estimate how long the FAANG companies will dominate their respective environments, well, then the investment decision to make is easy.

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