Here’s why all insane valuations will eventually become sane one way or another

The share market, and most other asset classes, have reached continuous highs over the last couple of years.

We’ve seen other types of valuations used, like a multiple of sales, to justify a high valuation.

Anyone paying for a businesses valued at over 100x the last year’s earnings, or even next year’s earnings, are pricing in some big expectations.

Some of the shares to trade with those huge triple digit valuations in recent history include Kogan.Com Ltd (ASX: KGN), Medical Developments International Ltd (ASX: MVP) and Afterpay Touch Group Ltd (ASX: APT).

I may have cherry picked those examples, but they have all fallen significantly since their all-time highs. If you buy at an extremely high valuation the growth expectations are priced in for years.

That means there’s a period of several financial years where the market may decide your hotshot stock isn’t worth as much as you think.

Rising interest rates mean that only the worthiest of fast-growing businesses can command such a multiple. WiseTech Global Ltd (ASX: WTC) has fallen more than 25% since September yet it still trades at 81x FY19’s estimated earnings. It’s trading at 39x FY21’s earnings, which is still a hefty price.

Electronic PCB software market darling Altium Limited (ASX: ALU) is ‘only’ trading at 40x FY19’s earnings – it seems like a bargain compared to WiseTech!

Of course, the same can be said in reverse. A business that is trading with a very low valuation and achieves profit growth will eventually be too cheap for the market to ignore. I thought Zenitas Healthcare Limited (ASX: ZNT) was too cheap to ignore for a business growing nicely organically.

Foolish takeaway

Two shares that seem to be trading very cheaply to me are Paragon Care Ltd (ASX: PGC) and Apiam Animal Health Ltd (ASX: AHX). They are both achieving decent organic growth and are trading at around 10x FY19’s estimated earnings.