Why Do So Many Biotech Stocks Have Such High P/S Valuations?

When people in the investing world talk about a stock that looks "expensive," they're almost never talking about the actual share price. That doesn't tell you much at all out of context. For example, shares of auto-parts retailer AutoZone trade above $1,000, while Apple, which is 35 times larger, trades in the neighborhood of $200.

But the real questions of pricey vs. cheap get answered in the ratios like price-to-earnings, which tells you how much investors are willing to pay for each dollar of profit the company accrues. Or price-to-revenue, which measures the company's value relative to its total annual sales. On that last score, the market tends to give businesses in some industries more credit than others. And biotech is one of them.

In this mailbag segment from the Rule Breaker Investing podcast, listener Luke Joseph asks why fast-growing biotech companies seem to fly a bit too far above the norm -- and above his comfort level -- when it comes to valuation. To help explain, Motley Fool co-founder David Gardner brings in a couple of biotech-sector specialists -- senior analysts Karl Thiel and Aaron Bush. And later, they segue into a similar question of how to properly value tech companies when they're still in their "negative earnings" stages.

A full transcript follows the video.

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This video was recorded on March 27, 2019.

David Gardner: Rule Breaker mailbag item No. 2. This comes from Luke Joseph, writing from Sydney, Australia. Luke, thank you for being a Rule Breakers member! And, yes, I do tend to prioritize questions from members on this podcast. Now, we welcome all questions here at The Motley Fool. We truly are trying to make the whole world smarter, happier and richer. But when somebody tells me -- Randy Stephenson -- that he's been a member since our AOL days, or -- Luke Joseph -- that from Sydney, Australia, you're a Rule Breakers member, there's a little bit of me that pushes you closer to the top of the queue.

Anyway, Luke, great question! You said, "I'm fully on board with the Rule Breakers style of investing. I've done well with many of your recommendations over the past three years. Like you, valuation is not usually a primary consideration for me when selecting whether or not to buy a stock. I usually prioritize a company's revenue growth rate, total addressable market, and proportion of recurring revenue." I like all three of those. Those are good things to look for, Luke. "I have no problem with paying upwards of 10X or even 20X revenue." So, the market cap of a stock would be 20X the sales, which is quite a high number. It looks high even to us, but we have similarly, Luke, had no problem, in some cases, doing that, "For a fast-growing enterprise software business. However, I've noticed that some of these fast-growing biotech companies can sit on a much higher valuation than this for a very long time. I'm thinking specifically of Guardant Health, Abiomed, and Mazor Robotics before its acquisition, which often had a price to sales ratio above 30X.

"I seem to have a problem paying this much for a business because I don't know why biotechs seem to be able to levitate on such high valuations for so long. Is it because they often have monopolies? Or is it because investors know that patients will have no choice [but] to buy their products eventually? I would appreciate if you could assemble a dream team of Karl Thiel, Aaron Bush, and yourself to explain why this is the case. Kind regards all the way from Sydney, Luke Joseph."

Luke, delighted to have your question! It is my pleasure to bring together the very dream team, Aaron Bush, that he just called out.

Aaron Bush: I'm so humbled to be on a dream team, period. Thank you! [laughs]

Gardner: So am I! I've never been before until now. This is why we have a podcast, so we can make ourselves a dream team.

Bush: Yeah, we should do this more often!

Gardner: And I want to say hello to Karl Thiel, calling in from his home somewhere in around Austin, Texas! Karl, how are you doing?

Karl Thiel: I'm doing well! Thank you!

Gardner: Good. Karl, you have made some great biotech selections for Motley Fool Rule Breakers over the years. Aaron, you have done a wonderful job picking stocks, many different types of stocks, both in Motley Fool Rule Breakers and other services, too. Luke wants to hear from you guys. I want to hear from you guys. Aaron, I'm going to kick it to you first. What do you think about when you look at a stock that's trading at a really high multiple of sales?

Bush: I would say everything is relative. A high multiple of sales probably indicates that the company is growing quickly, that people have high expectations. That's typically a very good thing, actually. It means the company is doing things right. It probably means that they're in a large market. In some cases, it's actually a reason to look deeper. Sometimes there's a difference between when a stock is overvalued and when people say it looks overvalued. I think a lot of times when you start seeing a lot of people say that a company is overvalued, that's almost the typical sentiment at any given time, even when a stock is trading at 20X sales, it often shows -- just based on what I've seen, learning from David and Karl and seeing lots of Rule Breaker picks over the years -- it often shows that, if that company does turn out to succeed and continue growing at fast rates for longer than people realize, some of those people who think that it is overvalued, they might change their minds. In some ways, the act of them changing their minds is what can push that stock up even higher.

Gardner: That's why attribute No. 6 of Rule Breaker Investing is: when people call out a stock as overvalued, that makes us bullish.

Now, Karl, you've specialized a lot in biotech. Do you have any particular biotech thoughts for Luke?

Thiel: Yeah, absolutely. Stepping back and being a little more basic about it, one of the reasons is because biotechs -- and it's not just biotech, but they're a good example -- have extraordinarily high margins. They're always going to have a higher price to sales multiple. Just an example of, say, a grocery store chain that tends to get a ton of revenue but makes very little profit on it, they're going to trade at probably less than 1X sales. A company with extraordinarily high profit margins is always going to trade at a higher multiple sales. That's just a very basic reason.

Another reason is, ultimately a company is worth what the market thinks it's worth. It's been shown time and time again that biotechs, particularly smaller and mid-cap biotechs, will command take-out prices that are at these kinds of price to sales multiples. That's a real grounding in reality of what something is truly worth to somebody else. You see that happen particularly with companies that are also expected to see those sales grow very quickly. That's why you'll tend to see these multiples be higher for, like I said, smaller and mid-cap companies.

Bush: Yeah, I would say, you do see similar attributes in the software industry as well. It's probably less explosive, less binary, in a lot of ways. But there are some similarities in the sense that this is a trend that is taking over workplaces. A lot of these companies are adapting these technologies very quickly.

Gardner: In enterprise software, you're talking about.

Bush: Yes, in enterprise software. Lots of companies are jumping on board very quickly. It's very sticky. Once they're in, they're staying in. And what we're seeing a lot nowadays is what we consider a net expansion rate. These companies literally are spending oftentimes 20% or 30% more the next year just on upgrades and all sorts of things. When you look at these software companies at scale, they also are very profitable -- potentially 30% of their revenue turns into cash flow.

So I think we're seeing high price to sales ratios not because of what the company's economics look like today, but what they will be many years from now. So instead of thinking about that one ratio, I think it's more interesting just to look at the market cap itself. Think about what could that market cap be at some point in the future. Hopefully, if you can think of a much bigger number, then today's ratio is less important.

Gardner: That's why we play The Market Cap Game Show. We've even made that into a game show on Rule Breaker Investing! I agree with you, Aaron, that market cap is a really helpful guide for us.

Karl, I also have a second question I'm going to thread into this same point. Colin Anderson wrote in, and he was talking about how he also loves Rule Breaker Investing, but he does look over his portfolio, and he sees a number of his companies, companies like MongoDB or Square or, at different stages, Shopify, with negative earnings; companies that do not have a price to earnings ratio because they do not have earnings. Is this the same consideration again? A multiple that in this case doesn't even exist? Should we feel comfortable owning these companies? Which comes with no earnings would you prefer to own over the other ones that you wouldn't want to own?

Thiel: Right. Obviously, a company that never earns money is not a worthwhile investment. Every time you see a company that has negative earnings, and is positively valued, that's on the assumption that it will eventually start earning money or producing cash flow for its investors. The numbers can be tricky, right? A company that just turned profitable, produced three or four pennies of profit during the last year, might have a price to earnings ratio in the hundreds all of a sudden. But what you're looking at is, how quickly is this going to grow into something? Particularly as a company first steps into profitability, that can happen extraordinarily quickly, which is why it's good to look a good ways ahead and think about, not what are earnings today, but what are earnings going to look like.

Bush: One topic that venture capitalists particularly pay attention to is the idea of unit economics. Less of what are the economics of the entire company at one point, but what are the economics of acquiring one user, and then their lifetime value and the value that they bring to the company?

Gardner: That's unit economics, where you take a single customer, you see, what is the economic dynamic around that customer? Then you project it out to others.

Bush: Right. It's just another way of looking at what could this company, what could their economics be in the long run, once those unit economics start becoming the norm for everybody?

Gardner: People do that with retail stores. You might look at a single Potbelly or a single Starbucks back in the day and go, "Hmm, what if there were a lot more of these? We could maybe make some better projections about the value of that entity."

Bush: Right. There are different ways to slice and dice the numbers, but I do think unit economics is particularly helpful when companies are losing money.

Gardner: Alright, so there's some thoughts from three different Rule Breakers. One man's dream team, if you will. Aaron, Karl, thank you very much!

Bush: Thanks, David!

Thiel: Thank you!

Aaron Bush owns shares of Abiomed, Mongo DB, Shopify, Square, Starbucks, and Apple. David Gardner owns shares of Apple and Starbucks. Karl Thiel owns shares of Apple. The Motley Fool owns shares of and recommends Abiomed, Guardant Health, MongoDB, Shopify, Square, and Starbucks. The Motley Fool owns shares of and recommends Apple. The Motley Fool has the following options: short January 2020 $155 calls on Apple and long January 2020 $150 calls on Apple. The Motley Fool has a disclosure policy.