Investors should always look beyond the king of valuation metrics, the P/E.
Earlier this month, Peloton Interactive (NASDAQ:PTON), the connected home-fitness leader, reported strong fiscal first-quarter 2021 results (for the period ended Sept. 30). Revenue soared 232% year over year to $757.9 million. Net income was $69.3 million, or $0.20 per share, versus a net loss of $49.8 million, or $1.29 per share, in the year-ago period.
Peloton’s results have gotten a huge boost from the COVID-19 pandemic, which has driven more people to exercise in the safety of their homes. Combine this tailwind with the company’s value proposition that was already attractive before the pandemic — making exercising more enjoyable for many people — and it’s not surprising that shares have rocketed. In 2020, Peloton stock is up 284% through Nov. 27, compared with the S&P 500 index’s 14.5% return.
As you’d expect for such a fast-growing company, Peloton’s stock is highly valued. However, the good news is that it’s not nearly as outrageously pricey from a valuation standpoint as many investors probably believe. This is because many investors likely consider just the stock’s price-to-earnings (P/E) ratio, which has major limitations as a stand-alone valuation metric.
Look beyond just the P/E ratio to cash flow valuation metrics
If you read many articles about stocks, you’d probably be rich if you got a few bucks every time you read something like:
- X stock is highly (or over-) valued because its P/E ratio is Y.
- With projected five-year earnings per share (EPS) growth of W and forward P/E of Z, X stock seems too richly priced.
The above sentences are overly simplistic. It’s not possible to make a good call about a stock’s valuation using just a P/E ratio. A main issue with the P/E ratio (trailing or forward) has to do with its denominator: earnings, or EPS. Net income, or “earnings,” is just an accounting measure. All sorts of things — legitimate and not — can greatly affect a company’s reported earnings.
Cash flows, on the other hand, are the real McCoys when it comes to money and, thus, more accurately reflect how a business is performing, at least over longer periods. Short of outright fraud or incompetency, a company’s reported cash flows (operating cash flow and free cash flow) are what they are.
This is why professional investors pay much attention to cash flows, and don’t simply focus on net income or earnings when a company reports its quarterly results.
Peloton’s stock valuation: P/E vs. P/FCF
Peloton stock has a sky-high P/E ratio of 389 based on the stock’s closing price on Friday, Nov. 27. That means the stock is priced at 389 times the company’s earnings per share (EPS) over the trailing 12 months.
Also as of Friday’s market close, Peloton stock has a price-to-free cash flow (P/FCF) ratio of 56.9. That means the stock is priced at about 57 times the FCF per share the company generated over the trailing 12 months. Granted, a P/FCF ratio of 57 is still high — but it’s a heck of a lot lower than the P/E of 389. Given how fast the company is growing, a 57 P/FCF ratio isn’t outrageous.