Guest Post: The Laugh Test

Today we have a contribution from Ari Kuchinsky, who writes about the stock market, technology and often the intersection of the two.  I thought this was a brilliant shortcut for the first-glance, initial evaluation of stocks.  Enjoy! – JB

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The Laugh Test

What does it really mean when a company IPOs at a valuation of $2 billion? It is easy to get lost in the big numbers when we can’t visualize what it means. Using relative valuations can be a big help. I make it into a game.

Did you know that LinkedIn’s ($LNKD) market cap of $6.4B is greater than the $5.87B market cap of Southwest Airlines ($LUV)? Groupon’s ($GRPN) $10.89B valuation (down from $16.70B just a week ago) sounds even higher than it does in the abstract when you consider that Marriott’s ($MAR) market cap is $9.48B and Whole Foods ($WFM) is valued at $11.34B. Pandora’s ($P) $1.91B market cap feels really expensive when you consider it has approximately the same market cap as well known brands such as Wendy’s ($WEN) and Domino’s Pizza ($DPZ).

When I evaluate stocks for holding over a period of months or years, I use my market cap laugh test. I can eliminate a lot of overpriced stocks with it. It is especially helpful when a stock has fallen in value making us think that the stock is “cheap” and a “value play.” More often than not, after running the stock through the laugh test, it turns out to still be expensive.

I play the game comparing the relative valuation of well known companies and brands with  speculative companies and IPOs. For example, is it really probable that Pandora has a ton of upside potential when it already is valued as being worth as much as Wendy’s and Domino’s Pizza? While these are completely different businesses, it is hard to envision a company selling streaming music over the Internet being worth more than these well known fast food brands (think about what Pandora offers and think about Wendy’s locations everywhere). Even if I am completely wrong and don’t appreciate the long term value and growth of Pandora, it is hard to see it being worth more than streaming movie provider Netflix ($NFLX) ($3.70B) or satellite radio broadcaster Sirius XM Radio ($SIRI) ($6.99B). When I look at Pandora on a relative basis, the upside seems very limited when Netflix is only valued at $3.70B.  Pandora doesn’t pass my laugh test even after the big drop from its IPO price.

Next, fire up your browser and visit bankrate.com and creditcards.com. Spend about two minutes using each website.  Bankrate ($RATE), the owner of bankrate.com and creditcards.com, has a market cap of $1.6B. Is this the website of a $1.6B enterprise?  So what does $1.6B translate to in the current market? Brinker International ($EAT), the operator of Chili’s and Maggiano’s restaurants has a market cap of $1.8B. The Cheesecake Factory ($CAKE) has a market cap of $1.44B. Visualize all of those Chili’s locations side-by-side with the bankrate.com and creditcards.com websites. Chuckle chuckle.

Note: Market capitalization is based on prices the morning of November 23rd.

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About Ari:

Ari has been watching stock prices since he bought one share of duPont in the fifth grade and has been a computer geek since he started visiting and running bulletin board systems (BBS) in the late 1980s. Professionally, Ari is a commercial real estate attorney in Austin, Texas and holds a law degree from Vanderbilt and a business degree from the University of Florida. The opinions expressed by Ari are in his personal capacity and are not associated with any other person or entity.

Follow Ari Kuchinsky on Twitter:  @arikuchinsky