This article was first published in the National Post on December 5, 2020. It is being republished with permission.

by Tom Bradley

“Baked in the cake” is a commonly used investment phrase that refers to the ingredients, or assumptions, that go into a stock price. For example: “Company ABC is trading at 100 times earnings. It looks like its sales growth is baked in the cake.” Or: “XYZ had an awful earnings report today, but the stock went up. I guess all the bad news is baked in.”

The news on the business channels this week was all about baking. The discussions weren’t about how good a company Tesla or Zoom are, but rather how much growth investors were already counting on.

Remember, stocks reflect investor expectations for future profits and dividends. Prices move when expectations change.

Ludicrous mode

Tesla is the stock-market story of the year, maybe the decade. It’s up more than 600% since January and will be the largest company ever to be added to the S&P 500 index. I don’t own a Tesla, but have driven enough of them to know that the “computer on wheels” experience is intoxicating, the acceleration is, well, ludicrous, and my friends who own them are insufferable.

Having said that, I’m more likely to own the car in the next year or two than the stock. The car is in a high price category, but the stock is in a world of its own. Its price-to-earnings multiple is in the hundreds and the company’s value exceeds all the other major car companies combined.

In an interview on CNBC, Daniel Ives, an analyst at Wedbush Securities, captured the enthusiasm for Tesla with phrases such as, “It’s a new paradigm as far as the growth opportunity and how it’s valued,” and, “In China, we’re really seeing an inflection point.” He also said, “The adoption curve (for electric vehicles) is increasing,” and, “It’s a disruptive technology company.”

We know there’s lots of optimism built into the stock when phrases such as new paradigm, inflection point, adoption curve and disruptive technology all come up in a five-minute interview.

Who’s zoomin’ who?

Aretha Franklin’s 1985 hit could be the theme song for 2020. Videoconferencing company Zoom was in the right place at the right time and this week reported explosive third-quarter results. But something interesting happened. The stock went down on the news. It would appear that, at least for a moment, the assumptions built into the stock are even more spectacular than what was reported.

It’s a scary time in the cycle for investors who are disciplined about price. I’m hearing too many analysts and fund managers say that valuation is secondary to companies’ positioning and growth rate. In other words, the factor that best predicts future returns is being put on the backburner. Story and momentum are everything.

Gravity

Stocks and markets can disregard valuation for long stretches if the news is good and the numbers are accelerating. But they can’t defy gravity forever. No stock can sustain a 100-times multiple (although Amazon.com Inc. is giving it a good go). When growth slows, the P/E multiple will move back to join the other stocks in the 10- to 30-times range.

On this point, I hearken back to Cisco Systems Inc.’s days during the tech boom. It was a market darling back then and traded up to US$77. Since then, the company has been highly successful and gushed profits, but couldn’t live up to investors’ lofty expectations. After a strong four-year rally, it’s still 40% below its 2000 high.

Will the Zooms of this tech cycle be like the Ciscos of the last one? Is the reaction to Zoom’s stellar earnings telling us that valuation concerns are creeping back into the conversation?

Howard Marks wasn’t talking about a bond or stock’s next big move when he said, “No asset can be considered a good idea (or a bad idea) without reference to its price.” He was referring to the economic gravity that eventually pulls a security to a level that can be justified by future profits.

It’s important to determine if Tesla will disrupt, and whether Zoom will be insanely profitable, but it’s also necessary to understand what assumptions buyers are using in their models. You don’t want them to be more optimistic than you are. Put another way, you don’t want too much of the potential you’re excited about to be baked in the cake.