Just this from IBD. Reprint of the same article in paper edition.
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Investor's Corner Look Far Into The Future To Value Story Stocks
Investors Business Daily, Monday, May 11, 1998 at 12:43
The CFO of America Online Inc. recently declared that his
company's $75 stock was really worth $150, even though it's only on
track to earn 45 cents a share. Last week, shares of EntreMed Inc.,
a medical research firm, soared as high as 85 from the previous close
of 12 on news of a promising new cancer treatment.
What makes AOL worth 150? And who would want to own EntreMed,
whose accountants have been writing only with red ink for six years?
I N V E S T O R ' S C O R N E R
How do you value a company whose high hopes far outstrip any
current profits?
There are a bunch of stocks in this quagmire. Many are high-tech
or medical research companies. The bottom line, some say, is that
there's more to a company than its bottom line. Earnings are still
important. Maybe not current earnings, but those expected down the
road - perhaps years away.
"The first thing for an analyst to do is to present a model that
projects revenue, a discounted cashflow model, with about five to 10
years of (net present value)," said Richard Cripps, director of
equity marketing at Legg Mason Wood Walker Inc. in Baltimore.
Future Earnings
Net present value is the key concept when looking at a company
with plenty of potential light at the end of a long tunnel. NPV is
the current value of a future flow of profits. That's why a company
like EntreMed can see its shares soar despite never having turned a
profit. If its cancer treatment is even a fraction as successful as
some are daring to hope, it'll make a fortune.
But using an NPV approach can be tricky. Cripps says the
variables should be re-examined and modified frequently. Key among
those variables is the expected cash flow, say, two, five and 10
years down the road. For a company like Chrysler Corp., cash flows
are somewhat predictable. That makes for a fairly easy NPV
calculation.
But what about the NPV of America Online's future flow of
earnings? AOL's future depends on online services, including the
Internet, as well as its own members-only online system. Analysts
see almost unlimited potential in this area.
This is where the problems begin. How does one quantify almost
unlimited potential? Different analysts, using the same method, can
come up with widely different results. That's one reason why some of
these yet-toearn-a-penny stocks fluctuate so wildly.
"It's all very subjective," said Ken Gehl, senior vice president
at Everen Securities in Chicago. "That doesn't mean you don't do it.
You have to" - if you're going to play these stocks.
Wide ranges in future earnings estimates make for wide swings in
the stock. Take Internet search engine Lycos Inc., which came public
two years ago. The Framingham, Mass.-based company just turned the
corner after eight straight losing quarters. Analysts don't expect
it to notch an annual profit until next year. The company's IPO was
priced at $15, and those who bought and held have a nice profit of
more than 300%.
Wild Swings
But it's been a wild ride. The stock, already on a long-term
upswing, picked up steam in early April. It soared from 43 1/2 to 79
1/8 two weeks later. Less than two weeks after that, it was back to
47 1/2. A week later, it was back up to 70 1/2.
"It's the nature of the beast," Gehl said. "And it's the nature
of the player in that stock." It takes a certain personality to play
a stock that moves like that. "A type-A personality," he said. And
Lycos wouldn't move the way it does if its earnings were more
assured.
How subjective is the value game? Cripps points to Amazon.com
Inc. as a case in point.
The online bookseller's $2.2 billion market capitalization is
nearly equal to that of Barnes & Noble Inc. But the two book
retailers have vastly different earnings pictures. "Barnes & Noble
has a thousand stores. Amazon doesn't have that infrastructure
cost," Scripps said.
But Barnes & Noble, even after spending to maintain those stores
and for personnel, earned 93 cents per share last year and should
make $1.15 this year. Amazon.com, in contrast, will lose $1.34 this
year, and will make only a skinny nickel in '99.
So why is money-losing Amazon.com valued as highly as the
profitable Barnes & Noble? "The answer is overoptimism on Amazon,
and the expectation that they have a superior model in terms of
profit margin in book-selling," Scripps said.
But Barnes & Noble also sells books over the Internet at
comparable prices and service. So what's really going on here?
Scripps offers this explanation: "On Wall Street, the high-tech guy
is analyzing Amazon, the retail guy is following Barnes & Noble.
"The usual standards (of valuation) are not being applied to
Amazon. It's still a technology company," he said. Of course, it's
still a bookseller. "If it (Amazon.com) was an industrial company,
it would be a $5 stock, if that," he added.
Barnes & Noble is valued by analysts using the usual standards.
That's why its market valuation is the same as Amazon.com's, despite
its vastly better earnings.
So how does one deal with pie-in-the-sky stocks and industries?
A.C. Moore, chief investment strategist at Principal Financial
Services in Santa Barbara, Calif., has a few ideas. PFS manages
investments for wealthy individuals. Moore tends to avoid a lot of
industries and companies that have great promise, but no current
earnings.
"Most of our master-list companies have consistent earnings that
go back three or four decades," Moore said. "We are not comfortable
with companies that don't have earnings in hand." That's why Moore
stays away from what he calls "faddish," psychology-driven sectors,
like Internet stocks.
It may sound odd then, that PFS also runs The Biotech Fund, a $20
million unit trust focused on the biotechnology sector. But Moore
has a rational approach to this sector, well-known for its
hit-or-miss companies. What's his biotech secret?
"There, we need plenty of diversification," he said. "One company
may have difficulty. But if another doubles you break even. And if
it goes up four or five times, then you're making money."
Moore says there are about 24 companies in his biotech portfolio.
His approach is to use several types of diversification.
Diversify
First, he'll diversify among different companies spending time and
money to find a cure or treatment for the same disease. It becomes a
bit like a horse race. Moore likes to bet on both, if the numbers
are right.
Let's say Moore expects the stock of the loser will fall to zero.
The stock of the winner would have to more than double to make the
risk worthwhile. So Moore has to determine not just the downside for
the loser, but the upside for the winner. The analysis gets harder
when there are many players and more than one potential winner.
Real diversity, he says, means to spread the risk among shares of
companies chasing down breakthroughs in different areas: "Diabetes,
heart disease, different cancers, diagnostic methods," Moore said, to
name a few. To diversify one's holdings among a dozen companies
looking for a new diabetes treatment isn't good diversification,
Moore explained.
"Internet stocks are in vogue, . . . even Coca-Cola is in vogue.
That's all psychology. I think that's hazardous. But biotechs,
they're not in vogue. So there's no fluff to come out of them. And
if these companies do something extraordinary, there will be true
value created."
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