The greater fool theory is an investing metaphor that suggests that if you pay more for a stock than it is worth (intrinsic value indicates) that you are only doing this on the basis that a fool greater than you will come along and willingly pay you more. When you think about it, the greater fool theory is simply a warning to avoid taking unnecessary risk by paying too much for a stock.
Moreover, this notion is most often associated with high growth stocks that also are typically valued at high P/E ratios or other traditional valuation metrics. Classic examples would be the so-called FANG stocks, Facebook (FB), Amazon (AMZN), Netflix (NFLX) and Google (Alphabet) (GOOGL) which were originally given this acronym by Jim Cramer. These four iconic tech stocks are all high growth stocks, and they all trade at very high multiples relative to average companies.
However, the most interesting aspect and questions regarding the valuations of the 4 FANG stocks is whether they are justified or not. These are extremely difficult questions to answer correctly, especially when evaluating high growth stocks such as the FANGs. Furthermore, it’s important to consider and recognize the difference between justifying historical valuations versus justifying current and future valuations. Historical information – if garnered from a credible source – is typically accurate and reliable. Future information requires making forecasts into the unknown, and therefore, less likely to be accurate and/or reliable. This is a real conundrum for investors, because we can only invest in the future. We can learn from the past, but we cannot purchase it retroactively.
In addition to the general uncertainty of estimating future growth rates we also must be cognizant of being influenced by past results. The problem is that each of these FANG companies have grown into being multibillion-dollar behemoths with Amazon and Google approaching trillion-dollar market caps. For companies this big, the laws of large numbers clearly come into play. More simply stated, it is going to be much harder for each of these companies to grow at their historically fast rates the bigger they get.
Later in the FAST Graphs analyze out loud video I will be providing an analysis of the 4 FANG stocks utilizing several valuation references. The viewers will discover that there are several ways to value stocks in general, as well as the idiosyncrasies of valuing growth stocks in particular. Because true growth stocks like the FANGs do not pay dividends, they are all about capital gain. Furthermore, investors looking at growth stocks should also recognize that due to their high growth they will trade at significantly higher valuations (P/E ratios, price to cash flow ratios, price to EBITDA, etc.) than average companies. However, these higher valuations are justified due to the incredible rates of growth these companies achieve.