FANG Stocks Overvalued? Actually, a Majority May Be Cheaper Than Ever

Though the stock market has undergone an occasional hiccup since the Great Recession, this has been nothing short of an incredible bull-market run for more than nine years. At one point in January, all three of the major U.S. indexes had at least quadrupled from their March 2009 lows.

Although nearly every sector has played a role in pushing stock market valuations higher, a lot of credit goes to the fast-growing technology sector, which has flourished in the low-interest-rate environment. Being able to borrow money at a low rate has allowed tech companies to expand operations, acquire businesses, and hire new workers, thus lengthening an already robust growth cycle.

Image source: Facebook.

FANG stocks have taken the market by storm

But among the tech and service industries are a small group of stocks that are most credited with pushing the market higher in recent years: the FANG stocks. Originally named by CNBC Mad Money host Jim Cramer, the FANG stocks include:

  • Facebook (NASDAQ: FB)
  • Netflix (NASDAQ: NFLX)

When first dubbed the FANG stocks, Alphabet was known simply as Google, making it the “G” in FANG. It changed its name to reflect the addition of properties beyond its search engine, such as YouTube.

All four of these technology and consumer service juggernauts have been virtually unstoppable since the market bottomed on March 9, 2009. Here’s a snapshot of the aggregate returns of all four companies since that date, and through the market close on June 25:

  • Facebook: up 515% (since its May 2012 IPO)
  • Amazon: up 1,966%
  • Netflix: up 5,634%
  • Alphabet: up 455%

Amazon, Alphabet, Facebook, and Netflix have emerged from the shadows of significantly larger peers to grow into the second-, third-, fifth-, and 33rd-largest publicly traded companies by market cap, respectively, in the United States. Their growth and market-cap weighting makes them impossible to ignore.

Image source: Getty Images.

Are FANG stocks overpriced?

Yet, some on Wall Street have speculated that the FANG stocks could be overpriced and ripe for a pullback. After all, most stocks haven’t surged by nearly 2,000% or more than 5,600% over the past nine years, as is the case with Amazon and Netflix.

On a trailing 12-month basis, Facebook, Alphabet, Amazon, and Netflix have respective price-to-earnings ratios of 33, 56, 244, and 276. Fundamentally, they certainly look susceptible to a downside, especially if a trade war does blossom between the United States and either China or Europe. And if interest rates in the U.S. continue to climb, that would make borrowing money costlier, and could slow down growth rates throughout the entire tech sector.

Each of the FANG stocks has company-specific risks to contend with as well. For example, Facebook has to be concerned about its connection with the younger generation. If Generation Z begins leaving the platform, Facebook could lose out on its precious advertising pricing power.

Similar concerns could be echoed for Google, which is predominantly an ad-dependent platform, albeit it does have other sources of revenue. Any downturn in the U.S. or global economy could disrupt its money-making ad platform on desktop and mobile.

As for Netflix, it has to contend with the likes of Disney and other content providers encroaching on its streaming space. While Netflix does have a remarkable large library and unique shows, its peers have pockets that are plenty deep enough to give it a run for its money.

And then there’s the mighty Amazon, which has no shortage of retail competitors, and has drawn the ire of President Trump.

Image source: Getty Images.

Surprise! Most FANG stocks are cheaper than ever

However, if we were to look at FANG stocks from a different angle — namely, cash flow from operations growth in the years to come — they’re actually on track to be considerably cheaper than they’ve ever been.

While the price-to-earnings ratio is often the preferred measure of value for fundamental investors, it isn’t my favorite metric when analyzing the FANG stocks. The reason: These companies are now leaders in their respective industries, and they’re more than willing to use the cash flow generated from their operations to try new things.

This might mean dipping their fingers into new industries, expanding existing product lines, testing new features for existing products, or acquiring complementary businesses. It’s this cash flow that makes the hamster turn on its wheel for the FANG stocks; and it’s a far more intriguing metric relative to the price-to-earnings ratio.

With the exception of Netflix (which is why I allude to “most” FANG stocks looking cheaper than ever), the other three FANG stocks should see their cash flow per share (CFPS) explode higher in the years ahead. Netflix is reinvesting practically every cent of its cash flow into its international streaming expansion efforts and to bolstering its digital library, which will cause it to report an operating cash outflow, at least through 2019.

According to Wall Street, Amazon’s annual cash flow per share is expected to grow from $37.39 in 2017 to an estimated $132.90 by 2021. That represents a compound growth rate of 37.3%! As for Alphabet, its $53.52 in cash flow per share should practically double to $106.70 by 2021. Finally, while Wall Street doesn’t offer estimates of cash flow per share for Facebook beyond 2019, the social media giant is nonetheless expected to see its CFPS grow from $8.19 in 2017 to $11.63 in 2019.

Over the last five years, Amazon, Alphabet, and Facebook have averaged a price-to-CFPS ratio of 29.5, 18.7, and 33.3, respectively, per Morningstar. But based on Wall Street’s furthest available estimates of cash flow per share — i.e., 2019 for Facebook and 2021 for the other two companies — Amazon, Alphabet, and Facebook are looking at a price-to-CFPS ratio of 12.5, 10.7, and 16.9, respectively. These FANG stocks have never been this cheap on a forward basis with relation to their operating cash flow, albeit we are looking at good three years ahead for Amazon and Alphabet, and a lot could change in those three years.

While the stock market has shown time and again that no stock goes up in a straight line, I’d be willing to bet that Amazon, Alphabet, and Facebook still have significant long-term upside from their current valuations, even if a hiccup or two awaits.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Sean Williams has no position in any of the stocks mentioned. The Motley Fool owns shares of and recommends Alphabet (A shares), Alphabet (C shares), Amazon, Facebook, Netflix, and Walt Disney. The Motley Fool has a disclosure policy.

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