Peter, some interesting food for thought on how to value tech stocks.
Great Minds Wonder: What's Tech Worth?
By Steven Mufson
Washington Post Staff Writer
Wednesday, April 21, 1999; Page E01
Once upon a time, if the stock market fell by nearly 6 percent, the
Treasury secretary or Federal Reserve chairman would be pressed for
comment. The president's popularity ratings would tremble, and his
advisers would quake.
But in the world of technology investing, it's just another day. On Monday,
the technology-laden Nasdaq composite index plunged by 5.6 percent.
Yesterday, it popped up by 2.73 percent. Tomorrow, who knows?
Beneath the daily appearance and disappearance of billions of dollars of
market value lies a profound uncertainty about what constitutes value in
the world of technology investing. "Do we really know the intrinsic values
of what these things are?" asked Richard Cripps, chief equity market
strategist for Legg Mason Wood Walker Inc. "We don't. . . . We've not
seen these business models before."
The conundrum is illustrated by three companies at the center of the
technology boom: a hot prospect (RealNetworks), an established Internet
star (America Online) and a computer manufacturer (Dell Computer). By
any traditional measure of evaluating stocks, none of these companies
deserves the phenomenal surge in its stock prices. But technology is an
area that defies traditional business models and logic.
AOL, one of the biggest companies in the Standard & Poor's 500, is a
holding in Legg Mason's value-oriented mutual fund even though it is
selling for 572 times earnings.
And Dell grew from a per-share price of 66 cents to $83 in the five years
ended February this year. At that pace, the company would be worth $12
trillion in five more years, substantially more than the entire U.S. economy.
Does any of this make sense?
Some of it might, Cripps said cautiously. Take the Internet sector of the
stock market. Few people doubt that commerce conducted on the
Internet will alter American business and continue to multiply year after
year for the foreseeable future. How companies will make money from
that, and how much, is anyone's guess.
"Yes, it's frothy," said Cripps, referring to the Internet stock prices in
particular, "but there's also an element of truth in the market. If it's right,
how do we come up with a construct that explains it? We're in search of
facts to support our conclusions."
Some of the new measurements include calculations that translate
"eyeballs," or hits on an Internet site, into some as yet unrealized future
advertising revenue. Another technique: capitalizing advertising costs for
fast-growing, low-capital Internet firms in an effort to derive a meaningful
return on capital figure that can be compared with other industries.
Because many technology and Internet firms have no profits, analysts also
project future revenue, discount for the cost of money employed, and
guess at a future profit rate and price-to-earnings ratio.
Still, uncertainty breeds volatility, and few companies demonstrate that
more that RealNetworks, a Seattle-based company that markets software
and services that enable people to play audio and video on their
computers both live and on demand. On Monday, shares of
RealNetworks fell 24.5 percent, to $128.62 1/2 a share, less than half the
peak it hit on April 12. Yesterday, the company's stock soared 41
percent, to $181.06 1/4.
Rob Martin, an analyst at Friedman, Billings, Ramsey Group Inc., is one
of the company's fans. On April 12, he raised his price target for
RealNetworks, which lost 51 cents a share last year, to $300 a share, up
from a $200 target he set less than a month earlier. One reason for raising
the target: The old mark had already been shattered.
Martin argues that RealNetworks is positioned where Internet users are
going -- away from text and toward sound and video. The company
makes and sells a popular video browser, and it also has a World Wide
Web site that people can use to access video content.
RealNetworks' believers aren't limited to analysts like Martin or online
investors. One major investor in 1998: Fidelity Investments' giant
Contrafund, which owned $12.6 million of the stock on Dec. 31.
"The Internet is growing 100 percent year-to-year by any measure you
use, whether it's users, ad revenues or gross revenues," Martin said.
RealNetworks has 60 million persistent clients, he said -- an "inherently
valuable" base that Martin estimates will eventually translate into a $6
billion-a-year business. He predicts RealNetworks will make substantial
money by selling advertising to businesses that want to reach its viewers.
So far, however, it doesn't do that. Moreover, Microsoft and Apple might
enter the same market as competitors. "RealNetworks is subject to
massive valuations swings not uncommon among the Internet sector,"
Martin wrote recently.
Even Martin's optimistic scenario, however, would give RealNetworks
earnings of $2 a share in 2001, which at today's stock price would give it
a price-to-earnings ratio of 90, five times historic price-to-earnings ratios
for stocks.
AOL is a company with a slightly different model, but a controversial
valuation. Cripps notes that AOL is popular among fund managers
because it has a solid, paying customer base and should make money
from three sources: people who pay to connect to the AOL site,
advertisers who want to buy space on the Internet site, and marketers
who sell goods through the AOL site and give AOL a portion of the sales
revenue.
"It's a three-fer," said Cripps. But the stock, which Legg Mason fund
manager William Miller has long held in his value-oriented fund, no longer
seems quite as good a deal as it once was. The stock closed yesterday at
$128.68 3/4, up 10 percent for the day and more than seven times its
52-week low. Cripps said Miller has trimmed his position in AOL, and as
new money has poured into his fund, AOL's weighting has dropped
substantially.
Still, Cripps said AOL is a "cash-flow machine" and "will be worth more
five years from now than it is today."
Dell is another company that investors have been reexamining after five
spectacular years. The company's stock peaked on Feb. 2. Yesterday it
closed at $38.18 3/4, up $2.75. That was 30 percent below its high, but
at 52 times earnings still represented a premium of about three times
historic stock valuations.
Cripps said Dell deserves a high premium because the company has a
phenomenal return on capital. While most businesses employ substantial
capital and incur costs of borrowing, Dell manages its inventory using the
capital of its vendors, making it unusually profitable even though it is in the
highly competitive business of selling personal computers.
"The PC phenomenon mushroomed into the corporate sector. You have a
company that is executing very, very well with an innovative business
model," Cripps said. Although Dell's growth will inevitably slow, it could
still perform better than many other companies, he said.
© Copyright 1999 The Washington Post Company
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