The crash of 1987 happened as the yield curve was steepening

Summary

- It is generally considered a bad sign if the 10y-3mo or the 10y-2y differences in yields fall.

- This is particularly true if the differences in yields fall below zero (a yield curve inversion).

- However, the crash of 1987 happened as the yield curve was steepening, not flattening or inverting.

A crash without an inversion

When talk of a market crash intensifies, many people look for clues from the US Federal debt market to assess the probability of a crash happening soon. There is a widespread belief that the main clues come from Treasury yield differences, or the yields paid by US Federal debt instruments with different maturities.

It is a bad sign if the 10y-3mo or the 10y-2y differences in yields fall below zero (a yield curve inversion). However, as you can see on the figure below, the 1987 stock market crash happened around the time the 10y-3mo and 10y-2y yields peaked.

We show both the 10y-3mo and the 10y-2y differences in yields because some market experts have more confidence in the 10y-3mo signals, whereas others prefer those given by the 10y-2y differences. The reality seems to be that both the 10y-3mo and the 10y-2y differences in yields provide the same overall signals.

But the inversion preceded the recession

Having said that, the 1987 crash was followed by another smaller crash, related to the 1990 recession. This recession was indeed preceded by a yield curve inversion.

So, one could say that the yield curve inversion worked yet again, as it has done repeatedly, as a leading indicator of a recession.

Conclusion

The yield curve inversion phenomenon is a very good predictor of economic recessions, arguably one of the best leading indicators available to investors. And market crashes usually happen around recessions. But a market crash may happen without an economic recession.

In fact, the crash of 1987 happened as the yield curve was steepening, which is essentially the opposite of flattening – and arguably a bullish signal.

A simulation-based valuation of Alphabet (GOOG): December 2021

Summary

- GOOG was founded in 1998 and is headquartered in Mountain View, California (). It derives most of its sales from online advertising services.

- In this post we provide a simulation-based (sim-based) valuation () of GOOG.

- Our sim-based analysis suggests the following fair values – stock price: $3,385.97, and price-to-earnings (PE) ratio: 32.57. GOOG trades at $2,942.38, so it appears to be undervalued, with a potential upside of about 15%.

- GOOG’s leadership position in a few areas, and broad base of ventures with explosive growth potential, could lead to PE expansion, which would make our estimates above rather conservative.

Alphabet (GOOG)

GOOG was founded in 1998 and is headquartered in Mountain View, California (). It derives most of its sales from online advertising services, although other areas are growing at an accelerated pace. It breaks down its operations into three segments: Google Services, Google Cloud, and Other Bets.

Notable sources of revenue in the Google Services segment are hardware sales (e.g. the Pixel phone); and ads on Android, Chrome, Google Maps, Google Play, and YouTube. Google Cloud provides cloud infrastructure services, on which other (mostly third party) applications are run. The Other Bets segment could be seen as a very successful venture capital business.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of GOOG.

At the time of this writing, the company had a profit margin of 30% and a price-to-earnings ratio of 28.3. The expected growth in earnings for the next 5 years is 30.09%, which is what we will use for the sim-based earnings growth rate. The table below summarizes our sim-based results.

Since our sim-based analysis uses a S&P 500 return as a basis, our results summarized on the table above suggest the following fair values – stock price: $3,385.97, and price-to-earnings (PE) ratio: 32.57. At the time of this writing, GOOG trades at $2,942.38, so it appears to be undervalued, with a potential upside of about 15%.

Final thoughts

Is inflation likely to become a problem for GOOG? We often hear from experts on business media outlets that inflation has a much more pernicious effect on growth stocks than value stocks. We looked into this issue in another post (). Our analyses suggested that growth stocks may do better under relatively high inflation (around 5%) than value stocks.

Moreover, GOOG’s leadership position in a few areas, and broad base of ventures with explosive growth potential, would allow it to: (a) raise its prices to make up for inflation; and (b) take advantage of the massive optionality generated by its Other Bets segment. Many other firms would not be in the same position, in part because the leaders in any industry are by definition only a few in number. All of this could lead to PE expansion, which would make our estimates conservative.

Finally, if the stock market experiences a correction, will GOOG shares go down? Mostly likely. In our view, that would be a buying opportunity.

Disclosure

The author owns GOOG shares at the time of this writing.

A simulation-based valuation of Uber Technologies (UBER): November 2021

Summary

- Uber Technologies (UBER) is an American company () that provides mobility as a service.

- In this post we provide a simulation-based (sim-based) valuation () of UBER.

- Our results suggest the following fair values – stock price: $106.99, and price-to-earnings ratio: 130.65.

- At the time of this writing, UBER trades at $45.12, so it appears to be undervalued, with a potential upside of 137.12%.

Uber Technologies (UBER)

Uber Technologies (UBER) is an American company () that provides logistics services of a genre that is sometimes called “mobility as a service”. It does not own any transportation assets (e.g., cars, or trucks), and is headquartered in San Francisco, California.

Its services are constantly expanding, and currently include: ride-hailing, food delivery, package delivery, freight transportation, electric bicycle and motorized scooter rental, and ferry transport. UBER receives a commission on fares, often of 25%. These fares are quoted to each customer in advance, using a dynamic pricing model.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of UBER.

At the time of this writing, the company had a negative net profit margin of -17% and a price-to-sales ratio of 5.51. UBER’s estimated earnings growth rate for the next 5 years is 59.34%. We used 10% for net profit margin in our sim-based analysis; this is the margin of Avis, a car rental company.

Note that we assumed a positive net profit margin for a company that actually has a negative margin; we explained the rationale for this, in the context of our sim-based analyses, earlier in this blog ().

The table below summarize our sim-based results.

Since our sim-based analysis uses a S&P 500 return as a basis, our results summarized on the table above suggest the following fair values – stock price: $106.99, and price-to-earnings ratio: 130.65. At the time of this writing, UBER trades at $45.12, so it appears to be undervalued, with a potential upside of 137.12%.

Final thoughts

UBER has the potential to become a one-stop shop for all transportation needs, which makes its total addressable market quite large. Pressures to provide benefits to drivers will probably continue, but these may in fact create barriers for smaller competitors, further solidifying UBER’s leadership position.

One could argue that the development of autonomous vehicles could significantly increase UBER’s profit margins, but it is also possible that the developers of the technologies enabling autonomous vehicles will provide logistics services that could drive UBER out of business.

Disclosure

The author owns UBER shares at the time of this writing.

A simulation-based valuation of Facebook (FB): October 2021

Summary

- FB is the largest online social network in the world (). Given its enormous reach, with 2.5 billion monthly active users, it is a much sought-after conveyor of ads.

- In this post we provide a simulation-based (sim-based) valuation () of FB.

- Our sim-based analysis suggests the following fair values – stock price: $417.67, and price-to-earnings ratio: 32.61. At the time of this writing, FB trades at $324, so it appears to be undervalued, with a potential upside of about 29%.

Facebook (FB)

FB is the largest online social network in the world (). Given its enormous reach, with 2.5 billion monthly active users, it is a much sought-after conveyor of ads. As such, most of its sales are from ads placed within its “ecosystem”: the Facebook app, Instagram, Messenger, WhatsApp, and various app-specific features. Ad sales represents more than 90% of FB’s total sales; with 50% being in the U.S. and Canada, and 25% in Europe.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of FB.

At the time of this writing the company had a profit margin of 37% and a price-to-earnings (PE) ratio of 25.3. The expected growth in earnings for the next 5 years is 28.6%, which is what we will use for the sim-based earnings growth rate. The table below summarizes our sim-based results.

Since our sim-based analysis uses a S&P 500 return as a basis, our results summarized on the table above suggest the following fair values – stock price: $417.67, and PE ratio: 32.61. At the time of this writing, FB trades at $324, so it appears to be undervalued, with a potential upside of about 29%.

Final thoughts

Is inflation likely to become a problem for FB? We often hear from experts on business media outlets that inflation has a much more pernicious effect on growth stocks than value stocks. We looked into this issue in another post (). Our analyses suggested that growth stocks may do better under relatively high inflation (around 5%) than value stocks.

Moreover, FB’s leadership position would allow it to raise its prices to make up for inflation. Many other firms would not be in the same position, as the leaders in any industry are by definition only a few in number. This could lead to PE expansion, which would make our estimate conservative.

Disclosure

The author owns FB shares at the time of this writing.

A simulation-based valuation of Eletrobrás (EBR): September 2021

Summary

- EBR is the largest utility company, both in Brazil and in Latin America, and one of the biggest clean energy utilities in the world – owing to its widespread use of hydroelectric facilities to generate energy (). It generates about 40% and transmits about 70% of Brazil’s electricity.

- In this post we provide a simulation-based (sim-based) valuation () of EBR.

- If we use 1% as our estimate of earnings growth for the next 5 years, which is the expected growth rate for the Brazilian economy, our sim-based analysis results suggest the following fair values – stock price: $8.02, and price-to-earnings ratio: 7.54. At the time of this writing, EBR trades at $7.11, so it appears to be undervalued, with a potential upside of 12.80%.

- If we use 10% as our estimate of earnings growth for the next 5 years, which seems more reasonable given a likely increase in electricity demand and the possible sale of carbon credits, then a new sim-based analysis suggests the following fair values – stock price: $12.67, and price-to-earnings ratio: 11.92. With these numbers, the potential upside moves up to 78.20%.

Centrais Elétricas Brasileiras S.A. - Eletrobrás (EBR)

EBR is the largest utility company in Brazil and in Latin America, and one of the biggest clean energy utilities in the world – owing to its widespread use of hydroelectric facilities to generate energy (). It generates about 40% and transmits about 70% of Brazil’s electricity.

The Brazilian federal government owns a bit more than 50 percent of the company. The company is expected to be privatized soon. Nevertheless, some of its assets should remain under government control even after privatization – e.g., the binational Itaipu hydroelectric power plant.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of EBR.

At the time of this writing the company had a profit margin of 27.08% and a price-to-earnings ratio of 6.69. The expected growth in earnings for the next 5 years is not clear; but recent trends in electric vehicle adoption projections suggest solid potential. We will assume an earnings growth rate of 1%, which is the expected growth rate for the Brazilian economy, to be the sim-based earnings growth rate for the next 5 years.

The table below summarize our sim-based results.

Since our sim-based analysis uses a S&P 500 return as a basis, our results summarized on the table above suggest the following fair values – stock price: $8.02, and price-to-earnings ratio: 7.54. At the time of this writing, EBR trades at $7.11, so it appears to be undervalued, with a potential upside of 12.80%.

Final thoughts

Our 1% growth projection is arguably very conservative, given the prospect of higher productivity from privatization, higher demand for electricity motivated by the growth in electric vehicle adoption, and the possibility of additional income via carbon credits.

It should be noted that hydroelectric generation is considered to be “green”, but the construction of hydroelectric plants usually has a devastating albeit localized environmental impact. Given this, income via carbon credits is very likely, because of the opposition to the building of new hydroelectric plants by the same groups who consider the ones already built to be green sources of energy.

If we use 10% as our estimate of earning growth, then a new sim-based analysis suggests the following fair values – stock price: $12.67, and price-to-earnings ratio: 11.92. With these numbers, the potential upside moves up to 78.20%. Overall, EBR seems like an asymmetric investment option at the moment, with limited downside and significant upside.

Disclosure

The author owns EBR shares at the time of this writing.

Must see video on historical progression of nominal GDPs over time

Must see video on historical progression of nominal GDPs for various countries over time.

A simulation-based valuation of Albemarle Corporation (ALB): August 2021

Summary

- ALB is a multinational producer of specialty chemicals, and the largest provider of lithium for electric vehicle batteries ().

- In this post we provide a simulation-based (sim-based) valuation () of ALB.

- At the time of this writing, the company had a trailing twelve months price-to-earnings ratio of 38.

- According to our sim-based analysis, the fair price-to-earnings ratio should be 63.57, leading to a current fair value of $393.14.

- ALB currently trades at $235.00, so it appears to be undervalued, with a potential upside of 67.23%.

- The above assumes an earnings growth rate of 43.85% per year going forward.

Albemarle Corporation (ALB)

ALB is a multinational producer of specialty chemicals, and the largest provider of lithium for electric vehicle batteries in the world (). Headquartered in Charlotte, North Carolina, the company operates in three main areas: Lithium and Advanced Materials, Bromine Specialties, and Refining Solutions. It serves several sectors, including: petroleum refining, consumer electronics, energy storage, construction, automotive, lubricants, and pharmaceuticals.

Estimating a fair value for the stock

In this post we provide a simulation-based (sim-based) valuation () of ALB.

At the time of this writing the company had a profit margin of 21.78% and a price-to-earnings ratio of 38. The expected growth in earnings for the next 5 years is not clear; but recent trends in electric vehicle adoption projections suggest enormous potential. We will assume an earnings growth rate of 43.85%, which is the expected growth rate for the coming year, to be the sim-based earnings growth rate for the next 5 years.

The table below summarize our sim-based results.

Since our sim-based analysis uses a S&P 500 return as a basis, our results summarized on the table above suggest the following fair values – stock price: $393.14, and price-to-earnings ratio: 63.57. At the time of this writing, ALB trades at $235.00, so it appears to be undervalued, with a potential upside of 67.23%. Yes, the company seems to be undervalued at the moment, even though its shares gained more than 150% in the last 12 months.

Final thoughts

Analysts have been slow to increase their fair value estimates for ALB, consistently lagging the market in this respect. For example, one of the highest fair value estimates at the moment is $250.00, by BMO Capital. There are many reasons for this disconnect, including: the expectation that supply of lithium will surpass demand, destroying profit margins; the possible availability of batteries using little or no lithium; and a decrease in demand for ALB’s other specialty chemicals.

ALB’s guidance tends to be conservative. Based on that, and other factors, the forward predicted price-to-earnings ratio is at the moment estimated to be 75, which does not look very good compared to the trailing twelve months price-to-earnings ratio of 38. However, the most recent (previous quarter) forward price-to-earnings ratio was 52, which turned out to be a poor predictor and much higher than the current 38.

Disclosure

The author owns ALB shares at the time of this writing.