This is the kind of chart every investor wants to see:
Click on image to zoom.
This parabolic chart is for Plug Power (PLUG), which has appreciated six-fold since New Year’s and is up an eye-watering 6,400% over the past year. Once a penny stock, it is now trading in double digits.
Those who got in on PLUG early are obviously very happy, but they also face a quandary: is it time to sell? Likewise, potential buyers who have missed this run-up need to ask if this growth is sustainable or set to continue, even at a slower pace. Bears on the other hand need to think carefully about shorting such a stock, asking whether momentum and hope could cause the stock to rise even further.
While we won’t answer any of these questions here, let’s take a look at how to answer these questions by identifying the main tools that professional investors use when modeling out any stock, regardless of its past growth.
Market Size and Market Capitalization
The first question any investor needs to ask is what market does a company operate in and how big is that market. Then the next question is how large is that company’s potential share of the market.
For example, market research firm IBISWorld estimates that the size of the global fast food market is $551 billion. McDonald’s (MCD) had total revenue of $28.1 billion in 2013, so its market share is about 5% of the total market. Surprisingly small, with plenty of room to grow.
This explains why MCD’s P/E ratio is around 17.7—investors expect the company to continue to grow. At the moment, investors are estimating that the company is worth about $97.6 billion, or 3.47x annual revenues (it’s also 11.1x annual operating income). The company is valued at this rate because investors expect McDonald’s to continue to make a profit, and for that profit to grow over time as expenses decline and revenues increase.
Now with a company like PLUG, the market is less clear-cut and less understood—which is why the market is rapidly changing its price on the company. To understand if the market is right or wrong in valuing the company at $10 per share, investors need to do the same calculations for the company as I have just done for McDonald’s. What is its market size? What is its market share? At what multiple is it currently trading relative to revenues and expenses?
Growth Prospects for Revenue and Competitive Risk
After answering these questions, the next question to ask is how much the company’s revenue is going to grow. MCD revenue grows at a decent 2-3% clip, and is stable and predictable enough that the stock’s price rises slowly but steadily, with a few bumps on the way.
This is obviously a very hard thing to calculate, especially for a new company such as PLUG. Much has been made of recent contracts with large retailers, but the market does not fully understand exactly how many more retailers will buy PLUG’s products in the future, and when. This is what individual investors should try to understand to get an edge.
Additionally, investors need to look at and think about competitive risk. The company has competitors (FCEL, BLDP, ZBB), which are all doing extremely well on the tail end of PLUG. This means a lot of money is flowing into the sector indiscriminately, on the hopes that fuel cell technology is going to see explosive growth. And it may, which is why investors should try to get a sense of the market size.
But then they need to think about market share, in order to allocate funds more efficiently in their portfolio between these and other companies in the space. Is PLUG uniquely differentiated? Can, say, FCEL, offer better products at a lower price? Is ZBB big enough to limit how many new contracts PLUG can get? These are all questions that investors need to ask while investing in this new sector.
Market Perceptions and Reality
Finally, investors need to weigh this fundamental knowledge of the companies and their industry with market expectations. Right now, the market is pricing the fuel cell market at well over $3 billion, if you look only at the market capitalizations of the largest tickers in this space. How much larger can those market caps become before investors decide they have reached the limit of just how valuable these companies can be?
Important to this question is when will these limitations come to flood the market, and will they cause the stock to crash to Earth and become oversold. If so, how much should investors invest in the names now to protect from missing out on future appreciation, and how much should they leave in cash to “buy the dips”?
These are the questions that savvy investors ask themselves, whether the name is a trendy momentum stock or a large cap boring stock like MCD. Investors who ask these questions and find answers will outperform the market, every time. Those who don’t will jump on trends, and probably jump off too early or too late, costing them in missed opportunities or even losses from buying at the peak of a trend.