The Wall Street Journal -- November 3, 1997
Manager's Journal:
Stocks Overvalued? Not in
the New Economy
----
By Lowell L. Bryan
Are stocks fundamentally overvalued? Is last week's turmoil
the beginning of a sustained bear market, as stocks return to
"normal" valuations? Almost certainly not. The world's
equity markets have been driven to today's levels for good
reasons: The cost of equity capital has declined, and the
value of intangible capital assets has increased dramatically.
There's no question that the world's stocks are priced
differently than they were at the start of the 1990s.
Market-to-book ratios of U.S. companies are now about
2-to-1, roughly double the average between 1945 and 1990.
Price/earnings ratios in the U.S. are at 25, vs. a historic
average of about 17. My colleagues at McKinsey and I
analyzed the performance of the 100 largest companies
world-wide and divided them into groups based on their
earnings growth and returns on book equity since 1991. We
then took the 20 of these companies with the least change in
absolute performance. These 20 companies had an average
increase in earnings of 3.8% compounded (little more than
inflation) while return on book equity was flat (9.9% in 1991
and 1996). Yet their market capitalization grew by 13.5%
compounded.
Since the performance of these companies was unchanged,
what must have changed was the price at which the market
valued that performance. Many attribute this change to
"irrational exuberance." But our research indicates that the
underlying cause is that the cost of equity capital is falling.
Research by McKinsey two years ago estimated that there
will be a $12 trillion increase in household financial assets by
2002 due to the aging of the developed world's population.
The research also found that the demographic forces driving
this extraordinary demand for financial assets will continue to
increase through at least 2010. Many of these household
savers, especially in the U.S., have begun to develop a clear
preference for equities over bank deposits or bonds.
At the same time, corporate investment in tangible capital
stock is declining. The ratio of revenue to the sum of
property, plant, equipment and inventory for U.S. companies
has increased by some 20% over the past 25 years. This
means that U.S. companies are using about $530 billion less
financial capital than they would have used otherwise. As
companies elsewhere follow the U.S. lead in improving
productivity, they too will release significant capital.
Meanwhile, governments in the developed world have
dramatically slowed down the pace of new debt issuance;
their bonds thus will absorb less household savings. In the
past two years, we have reduced our estimate of the amount
of government debt that will be outstanding in 2000 by $4
trillion. Our research also indicates it will be a decade or
more before emerging markets will have a significant impact
on world-wide supply and demand for capital. It therefore
appears that there will be plenty of liquid financial capital
seeking equity returns at least through the next decade. And
whereas market breaks quickly eliminate speculative demand,
it would take massive changes in investor demand, or
massive new debt issuance by governments, to increase the
cost of equity.
Also driving the market up is the strong performance of
companies pursuing global opportunities. To understand this
effect we took a different list of 100 global companies --
those with the greatest increase in market capitalization since
1992. These companies grew their market cap by 24%
compounded and produced returns to shareholders of 30%
compounded over the past five years. Overall, their market
capitalizations increased from $1.6 trillion to $4.7 trillion, of
which $2.7 trillion represents an increase in market value over
book. That is, their market-to-book ratios doubled, to 4.2
from 2.1.
Outstanding stock market performance for this group is not
surprising given that their earnings increased at 23%
compounded and their return on book equity increased from
9% to 17%. But is a market-to-book ratio of 4.2 reasonable?
It could well be. Consider that historic accounting
conventions understate both earnings and book capital when
companies spend on "intangibles" -- people, patents, brands,
software, customer bases and so forth -- which are
increasingly the sources of value in today's global economy.
Money that companies spend to create these intangible assets
is considered an "expense" rather than a capital investment.
For example, a rough estimate of the costs of the installed
base of software in the U.S. is over $1 trillion, but most of
this investment has been "expensed" even though as a
by-product of this spending, intangible assets are being
created that have value that will endure for years.
The inadequacy of our accounting conventions is not new.
What is new is that the forces driving us toward a global
economy -- deregulation, lower transaction costs, more liquid
capital markets -- have made the potential value of intangible
assets much higher. What's also new is that companies are
investing in these intangible assets more strategically and
consciously. Commercial life insurers, for example, are
building cross-border expansion plans around their ability to
understand risk rather than nondistinctive portfolio balancing
and selling skills.
Investors know this -- but we have no accounting
methodology for recognizing the value of investments in
intangible assets. As companies accelerate spending on
intangibles to capture global opportunities, "earnings" are
being understated while returns on book equity and
market-to-book and price/earnings ratios are being
overstated. In other words, current stock market valuations
are more reasonable than they appear.
As companies are learning how to use their intangible assets
by moving them around the world -- through licensing
agreements, alliances and other strategies -- they are also
learning how to create and hold options -- making
investments in brands, technologies, local market knowledge
and so forth in order to stake claims on future global
opportunities. Increasingly, investors are placing value on
these options.
Thus, we believe that many companies with high market
capitalizations have real option value built into their stock
price. When a company is a standalone, this option value is
transparent. The Internet search company Yahoo! has a
market capitalization of $1.4 billion on annualized revenues of
about $70 million and a book value of $110 million -- clearly
a reflection of its option value. Less obviously, companies
like General Electric, Smith Kline Beecham, Intel and
Citibank have real global option values built into their market
capitalizations.
These developments have outstripped the financial
accounting conventions, the capital budgeting methodologies
and even the mental models most firms use to run
themselves. Investors hoping for the market to fall to levels
that feel more "normal" are likely to have a very long wait.
---
Mr. Bryan is a partner in McKinsey's New York office. |
