Mike,
I'd like to make a few points about the new stock market model that Gene Epstein presents in Barrons.
I believe R&D is considered equivalent to capital spending and not expensed. I have minor problems with this idea. My main concern is that if you capitalize R&D and consider it an asset you must then depreciate it. I'm not sure the model is doing that. A major error in my view. When you apply this concept properly, the net effect becomes zero on book earnings except for the amount that represents the incremental R&D required as the company tries to grow. As an experiment, I "approximated" this methodology for Microsoft, Merck, Oracle, and a few other high R&D companies that typify the "new era". The net effect was to increase earnings by around 10%-15%. My guess is that if this change did not make a huge impact on these specific companies, the aggregate difference is not that significant. Furthermore, we've always had some companies that were huge R&D investors.
The model and Gene are underestimating the effect of stock option compensation on economic profit. Even the current footnote methodology required by FASB is not adequate. Truly extraordinary amounts of free cash flow are being absorbed by companies repurchasing exercised options in order to avoid dilution. If the footnote methodology is used alone, it must be noted that it is not capturing options granted more than a handful of years ago or the effect of options re-pricing. Two serious understatements.
Andrew Smithers of Smithers and Co. Ltd. has done extensive replacement cost calculations that suggest that even if software, R&D, and other "new era" assets are included, the market remains very significantly above its mean reverting replacement cost level.
The methodology suggests that the late 70's and early 80's were a period of significant overvaluation. This indicates a significant flaw in my mind. Stocks were trading at all time lows in terms of PEs, price/replacement cost, price/book value, etc.. at that time. Subsequent market movements indicate that those were bargain prices. In my opinion, (one not shared by many investors) a valuation method must presume some leveling effects between savings, investment, real interest rates, capital, return on capital, and GDP growth on an aggregate level. I believe the flaw in the model exposed by the early 80s is being exposed again in the 90s, just in the other direction. It is presently assuming that a high return on equity will co-exist with a low cost of capital indefinitely.
An examination of individual companies that have been around for many decades and whose basic business remains unchanged suggests that most are selling at the upper end of their historical range if not at all time highs.
The method fails to recognize the effect the bull market itself is having on profits. Excess capital gains are contributing to above average trading profits at financial firms and lowering the need for pension funding elsewhere. (in addition to other bubble effects that are helping government and business etc..)
Wayne |
