When looking at stock market tickers, it is easy to fall into the trap of judging a company by its absolute dollar price rather than what is actually being paid for its earnings. During the September 2 episode of Mad Money, Jim Cramer tackled the misconception by comparing two completely different tech players, including hardware and flash storage giant Sandisk Corporation (NASDAQ:SNDK) and enterprise software leader MongoDB, Inc. (NASDAQ:MDB). He stated:
Unfortunately, many people are like my late mom, who looked at stock prices, I guess you’d call it, in a vacuum. As mom saw it, disk drive maker Sandisk with a price of $1,553 would be considered far more expensive than enterprise software company MongoDB at $375… All these companies have different numbers of shares. They have different earnings per share. So where the stock’s trading, it’s a pure abstraction… Really doesn’t tell you much at all. Now, if you want to truly compare them, be able to figure out what’s expensive, what’s not, you need to figure out what the companies are supposed to earn for the next 12 months, readily available at almost any stock site, then you divide the stock price by the earnings, and you get something called the price to earnings multiple.
Comparing PE multiples is the apples to apples way to value one stock versus another. Or maybe you want to think about it algebraically. You want to figure out the M. You divide the stock price, P, by the earnings estimate, E, or P divided by E equals M. When you’re valuing a stock, you’re solving for M. And M is the secret sauce behind everything in this business.
Let’s look at it in action. You’ll understand. Sandisk is supposed to earn $212 a share. You divide the price of the stock by that estimate and you get a price to earnings multiple. Comes out about 7.3. Considering the average stock in the S&P sells for 21 times earnings, that’s a steal. Enterprise software company MongoDB on the other hand is supposed to earn just under $6.50. You divide that and the stock price and you get an M of nearly 58. Sandisk’s trading at 7.5 times earnings. See, that’s a heck of a lot cheaper than MongoDB trading at almost 58 times earnings. No wonder the latter plunged 13.5% today after a decent quarter. It’s too rich in this market, and too rich equals sell… MongoDB is a really good company but its quarter wasn’t perfect so it got killed.
Looking Past Nominal Share Prices
When evaluating investments, looking only at the dollar amount on a ticker can trick investors’ brain. Comparing a high nominal share price like Sandisk Corporation trading above $1,500 to a lower absolute price like MongoDB, Inc. sitting at $384 could be considered a rookie mistake if investors ignore share counts and earnings. Nominal price is just a number in a vacuum that does not reveal much about whether a business is actually a good deal. To make smart choices, investors must look past the surface ticker and focus on what the business generates in profits.
Core Strengths in Hardware and Enterprise Software
Both companies occupy important roles in the technology landscape through entirely different mechanisms. Sandisk Corporation operates in the hardware and data storage space, and provides components where massive earnings power can occasionally get masked by unique capital structures and cyclical waves. On the software side, MongoDB, Inc. plays a substantial role in modern application development by offering a flexible, document-based database platform that enterprises rely on for managing complex data workloads.
Valuation and Contrasting Risks
The stark contrast in their valuations highlights how different market segments price risk. Sandisk Corporation trades at a significantly low forward earnings multiples, making it look like an incredible bargain compared to the broader market average. However, hardware makers always carry cyclical exposure. MongoDB, Inc. sits on the opposite end of the spectrum, trading at an earnings multiple near 59, at the time of writing. Its multiple leaves less room for error. When a stock is priced for perfection, even a solid quarterly report is not enough to satisfy fast-money traders, leading to brutal corrections like MongoDB’s 13.5% plunge following an otherwise decent update.
Institutional Ownership and Market Positioning
According to Insider Monkey’s database tracking over 1000 elite hedge funds, Sandisk Corporation was held by 128 elite hedge funds in the second quarter, up from 114 in the previous quarter, with about 7.68 million shares sold short as of August 14. On the other hand, MongoDB, Inc. saw participation from 69 hedge funds in Q2 compared to 74 in the prior quarter, while its short interest sits at a much lower 3.62%.
Cramer’s side-by-side comparison serves as a reminder that nominal share price is a pure abstraction. By solving for the earnings multiple, investors can strip away the noise and see that an expensive-looking stock might actually be a steal, while a lower-priced stock can secretly carry a dangerous valuation.
READ NEXT: Salesforce (CRM) Stock Surges as Jim Cramer Says AI Fears Were Overstated and Jim Cramer Notes Abercrombie & Fitch (ANF) is a Buy on a Pullback After Earnings Surge.
Follow Insider Monkey on Google News
