The 20 Most Inflated Tech Stocks
Loren Fox
08/01/1999
UPSIDE Magazine
Copyright (c) 1999 Upside Media Inc. All Rights Reserved.
More and more, buying technology stocks is like shopping for a car. Investors either aim for something reasonably priced and settle for a Honda of a stock, or they buy the Mercedes of stocks they've been craving despite its sky-high sticker price.
Evidence from the stock market shows that investors have been choosing to grit their teeth and pony up for the stocks they want.
The result has been the tech sector's dizzying ascent. On July 1, the Dow Jones Industrial Average stood 23 percent higher than it was a year earlier, while in the same period, the Morgan Stanley High-Tech Index leaped 92.3 percent. "The valuations of technology stocks are at historically high proportions," says James Carroll, a portfolio manager at Loomis Sayles & Co., a Boston money-management firm.
The most popular stocks, such as software giant Microsoft Corp. and networking leader Cisco Systems Inc., have rocketed to new heights over the last couple of years. They are part of an elite caste of technology stocks that have broken away from the pack. In a self-perpetuating cycle, these few dozen popular issues have drawn more buyers, boosting their popularity and therefore their ability to attract even more investors. So these big stocks have been able to command very high -- even inflated -- valuations.
But investors must keep in mind that there's a difference between a good company and a good stock. After all, you can buy a good car but pay too much for it. So Upside endeavored to pick the 20 most inflated technology stocks, drawing from every corner of the tech universe, including hardware, software, telecommunications and the Internet.
Valuation methods
To assemble our list, we first selected our evaluation criteria. We started with the most popular stock-valuing method: assigning a multiple to the company's expected profits in the following year, thereby factoring in both growth and earnings power. For example, the Standard & Poor's 500-stock index, the barometer of the broad market, was trading on July 1 at roughly 27 times its estimated earnings per share in 2000. Historically, the S&P 500 has had a price-to-earnings ratio closer to 22.
Fast-growing technology companies have always commanded high valuations, so we factored in sales growth rate as well. It's not unusual for a high-growth stock to have a price-to-earnings ratio, or P/E, that is one and a half or two times its growth rate. Valuable brands and dominant leadership positions also earn a premium. Some promising companies have yet to turn a profit, and their stocks are often valued by multiples of cash flow or by other means.
Internet stocks pose a unique challenge. The Internet is a huge opportunity and some Internet companies will truly succeed, but many are valued based on the potential of their unproven business models. Skeptics would argue that nearly every Internet stock is inflated. But we attempted to apply some reasonable basis for valuing Net stocks, as Wall Street does.
For all stocks, we used Wall Street analysts' estimates for growth rates and earnings, which rely on making certain assumptions about future successes. This isn't a study in certainties. In late January, for instance, Ameritrade Holding Corp.'s 2000 revenue was forecast by one analyst at $286 million and by another at $438 million. This disparity underscores the fact that valuation can't be entirely reduced to equations.
"Some of these companies we don't have to struggle so hard to value," says Huachen Chen, co-manager of the Dresdner RCM Global Technology Fund. "With others, you have to make some rather dramatic assumptions. Valuation is an art, not a science."
The 20 most inflated technology stocks have several traits in common. Many are companies whose stories are well-known, so their stock prices already reflect future success. Some are companies that are expected to continue growing as fast as when they started. And some have risky new business models that investors assume will meet no obstacles on their way to tremendous success.
Some picks are members of the select group of large, popular stocks. An "in crowd" of stocks is not a new phenomenon. In the early 1970s, Wall Street fell in love with the "Nifty 50" stocks, composed mostly of drug and consumer-products companies that traded at more than 60 times their earnings, says Ned Riley, chief investment officer of BankBoston Corp. At the height of the Nifty 50 trend, Riley recalls, Avon Products Inc. had a P/E higher than 150.
Upside isn't advocating investment based solely on valuation. The best companies tend to command high valuations. But buying a richly valued stock often involves more downside risk than upside potential. Stocks don't stay at lofty heights forever. Indeed, these days Avon has a P/E of around 27. While we're not predicting dramatic plunges for these 20 stocks, lackluster performance is a possibility. That's what happened from late April to mid June: Inflation worries seized the market, and the big, expensive technology stocks essentially stood still while investors flocked to cheaper industrial stocks.
Holders of high-valuation stocks also find the stock market unforgiving when the issuing companies stumble. "The higher they are, the harder they fall," says Daniel Kunstler, a managing director at J.P. Morgan Securities Inc. "You are riding a tiger."
So far, investors have been generally willing to overlook such risks. But in this volatile market, trends have a way of suddenly reversing. As with customers entering a car dealership, the rule is "Let the buyer beware."
AMAZON.COM INC.
Few stocks stir as much debate as Amazon.com. The online retailer set the standard for losing money to build brand and market share, so it has become a proxy for debating the values of Internet stocks.
Amazon's revenue growth and brand awareness have been dazzling, and so has its expansion from bookseller to super-retailer and auctioneer. But even fans admit that owning Amazon's stock is something of a leap of faith, a bet that somehow this discount retailer will turn a profit within the next few years. A positive sign: Amazon has attracted a tremendous number of customers even though its prices aren't the absolute lowest on the Web.
But while Amazon looks like an Internet company that will remain standing when others fall, its stock is overpriced. To attain a price-to-sales ratio, let's use a method preferred by William Blair & Co. analyst Abishek Gami: net profit margins times sales growth rate. Analysts expect Amazon's sales to grow by 70 percent a year. Retailers rarely generate net margins of more than 10 percent, so let's be generous and assume Amazon will one day have 10 percent net margins. Multiplying 70 by 10 percent produces a multiple of seven. Credit Suisse First Boston Corp. predicts revenue of $2.3 billion in 2000. If Amazon were worth seven times that figure, its market capitalization would be $16.1 billion. On July 1, the market valued Amazon at $19.8 billion.
Of course, all this implies that Amazon will someday generate net profit margins. But after reporting first-quarter results, the company said it was boosting spending to build warehouses and fulfillment centers, and loss estimates for 2000 widened from 29 cents to $1.26 per share. The stock's subsequent drop shows that investors are getting impatient. Other leading e-commerce companies like E-Trade Group Inc. are expected to turn a profit next year. How long can Amazon.com keep riding on potential?
AMERICA ONLINE INC.
America Online has proved itself the only blue chip among Internet stocks, with its valuable brand name and whopping 17 million members. Earning a $121 billion market capitalization, AOL is the first grown-up of the Net. So rather than use the price-to-sales ratio applied to immature Net companies, we note that AOL shares trade at roughly 200 times its projected fiscal 2000 earnings of 57 cents per share. That's unheard-of for a company so large. Even a P/E half that size would reflect its 50 percent growth rate. Another knock: Operating margins for its fiscal third quarter (ending March 31, 1999) were just 16 percent, below the 20 percent that top tech companies generate.
AMERITRADE HOLDING CORP.
The explosive growth of online securities trading has benefited online brokers like Ameritrade, which has seen its market capitalization rise above $6 billion. And unlike many e-commerce businesses, Ameritrade is profitable. But its stock is overvalued for a company that isn't the market leader, especially when market share counts for so much in the Internet world. Ameritrade had 428,000 customers at the end of March, so the market values Ameritrade at nearly $14,500 per customer. By contrast, E-Trade Group Inc., a company twice Ameritrade's size, is valued at roughly $13,500 per customer. And E-Trade is expected to grow at a 45 percent clip, compared to Ameritrade's 30 percent.
@HOME NETWORK (EXCITE@HOME)
@Home, now Excite@Home, is the only pure play in the Net's broadband market, using cable modems to provide high-speed Internet access. Its key partnership with AT&T Corp. and its May 28 merger with Excite Inc. positions the company for market success. But broadband is still a small market: @Home had 460,000 subscribers at the end of March. "I don't believe there's going to be much of a broadband mass market until well into the next decade," says Ladenburg Thalmann & Co. analyst Youssef Squali. Yet while the market values America Online at roughly $8,000 per subscriber, it values @Home at more than $40,000 per subscriber (excluding the Excite merger). So @Home's July 1 market capitalization of $13.8 billion is a bit too broadband for us.
BROADCOM CORP.
This communications microprocessor maker has leapt to the forefront of "systems on a chip" technology and taken a lead in chips for broadband digital data transmission. A public company since April 1998, booming Broadcom is in an enviable position. But while Intel Corp. trades at 20 to 25 times forward earnings, and other fast-growing communications chipmakers trade at a rich 50 times forward earnings, Broadcom trades at a whopping 80 to 100 times earnings. "That's unheard-of for a chip company," says Donaldson Lufkin & Jenrette Inc. analyst Charles Boucher. "People think it's an Internet company."
CISCO SYSTEMS INC.
Networking giant Cisco is the classic high-valuation tech stock, loved by investors for consistently trumping analysts' expectations. Cisco enjoys peerless dominance in equipment that routes data through office networks, and the growth in Internet usage and telecommunications spending is propelling Cisco's business even further. However, the company's girth masks its vulnerability. Many observers believe Cisco simply doesn't offer leading-edge technology. Its 30 percent to 40 percent growth rate doesn't justify its forward P/E of roughly 70. Is Cisco really twice as good as other networking stocks, which trade at 30 times earnings?
CMGI INC.
Although CMGI is still involved in its original direct marketing business, Wall Street loves the company because it owns several Internet businesses and invests in Internet startups via three venture capital funds that it manages. With its VC arm boasting winners such as GeoCities and Lycos Inc., CMGI became synonymous with not only Internet stocks but also Internet-related IPOs. Its $10.7 billion market capitalization is 41 times estimated 2000 sales -- nearly twice the multiple of top-tier Net stocks. CMGI's premium assumes the value of its Internet investments will continue to soar along with the market for Net stocks. But that's too risky an assumption to support such a high valuation.
DELL COMPUTER CORP.
Dell's inclusion on this list is no indictment of the company's business model. King of direct-sale computers now and in the foreseeable future, Dell is a great company. And the market has noticed, awarding it a premium valuation. In the 10 years from 1989 through 1998, Dell's stock outperformed all other stocks, appreciating by more than 35,000 percent. Can any stock be expected to maintain that pace?
Dell's high valuation also carries high expectations, a perfect example of the risks inherent in expensive stocks. Dell developed a high P/E because Wall Street grew accustomed to the company's revenue increasing by 55 percent to 60 percent each year. On Feb. 16, Dell reported fiscal fourth-quarter earnings that met analysts' expectations, but its revenue had grown by only 38 percent. Dell shares tumbled, then lagged behind the rest of the market for months. The stock, which closed at a split-adjusted $44.94 on Feb. 12, ended July 1 at $36.63.
Even though Dell's P/E fell from more than 55 to 37, that valuation still hasn't caught up with the fact that the days of 55 percent growth are behind it. Not only are such growth rates harder to maintain once a company grows as large as Dell, but Dell's market has become more competitive, as nearly every other computer maker has entered the direct sales channel.
U.S. Bancorp Piper Jaffray analyst Ashok Kumar, for example, believes Dell is definitely overvalued. With Dell's growth rate now at about 35 percent, Kumar thinks Dell's stock should trade with a similar multiple -- around 35 times forward earnings.
That kind of P/E would still award Dell a premium, as the average computer hardware stock carries a P/E of 25 to 30. No other computer stock, though, comes close to Dell's current valuation.
EBAY INC.
EBay deserves credit for taking the lead in using the Internet as an interactive marketplace. The company's person-to-person auction business is more lucrative than conventional online retailing, with much higher profit margins. EBay is profitable, and analysts expect it will earn 41 cents a share in 2000. But Hambrecht & Quist LLC projects EBay's revenue will be $257 million in 2000, which means EBay's $18.7 billion market capitalization is 73 times that figure. Even if EBay were given twice the multiple of other Internet stocks because of operating margins that approach 30 percent, that would be a price-to-revenue multiple of 40 to 60.
EMC CORP.
EMC is the leader in products for storing and managing data in enterprise systems, a valuable market in light of the Internet's growth. That leadership helped the stock rise 274 percent in 1998, leaving it at a high valuation. But then EMC's stock dropped in April and has yet to recover. While that drop brought the company's valuation down, the stock still carries a forward P/E of about 40. That's too high, considering the company's projected growth rate is 30 percent. As for a premium, well, EMC's net profit margin is only about 20 percent -- not bad for a hardware company, but still half the net margin that Microsoft generates.
IVILLAGE INC.
An online community for women, IVillage offers 15 channels that cover personal finance, parenting and other topics. Because of IVillage's promising niche and heavyweight backers NBC and America Online, investors have embraced the stock. But this kind of demographic specialization is unproven as a Web business. Also, IVillage faces stiff competition in the women's segment from the likes of Women.com Networks (a close contender in Web traffic) and others. Nevertheless, as of July 1, the market valued the unprofitable IVillage at roughly $1.32 billion, or 25 times estimated 2000 revenue. With proven profit maker America Online looking inflated at 20 to 22 times 2000 revenue, IVillage seems overly expensive.
LEVEL 3 COMMUNICATIONS INC.
Data traffic growth requires a greater number of high-bandwidth pipes, hence the interest in Level 3. The company is building a global fiber network based entirely on superfast Internet protocol technology. The benchmark in this sector is Qwest Communications International Inc., which has essentially finished building its fiber network, albeit less advanced than Level 3's. Analysts project Qwest to hit $12 billion in revenue by fiscal 2005, while Level 3 will be two-thirds that size. So Level 3's market capitalization -- $22.2 billion, or 94 percent of Qwest's -- seems overdoing it.
LUCENT TECHNOLOGIES INC.
Here's an example of a superior company that has become a very expensive stock. As the largest communications equipment company, Lucent benefits from being the stock most investors will buy to get in on a fast-growing sector. But relative to other communications equipment makers, Lucent's annual sales growth of about 25 percent isn't that high. It trades, however, at 40 times 2000 earnings. Smaller communications equipment makers are growing at 30 percent a year or faster, yet trade at earnings multiples of 30 or less. Lucent deserves some premium for its brand, but not a multiple of 40.
MACROMEDIA INC.
Macromedia has become a high-growth, high-valuation stock because of its connection to the Internet: It makes software for creating and viewing Web pages. The problem with Macromedia's stock is that it trades at 60 to 65 times forward earnings, and it's only growing at about 35 percent a year. Now, e-commerce software developers tend to trade at high valuations, but they are still software stocks. Macromedia shouldn't have a P/E that's almost twice its growth rate when it has yet to establish a consistent track record.
MICROSOFT CORP.
The software giant has its hand in everything from Internet portals to cable TV. Microsoft's stock trades at 50 to 55 times forward earnings because of its cash cow, the ubiquitous Windows operating system. But the huge company is growing slowly. "It's a great monopoly, but it's a monopoly of yesterday's technology," says Jeff Matthews, a portfolio manager at Ram Partners LP, a hedge fund. In new markets, Microsoft faces strong rivals, so its revenue is only projected to grow at 25 percent a year. While the company deserves a premium valuation, it doesn't warrant a P/E that's twice its growth rate.
PRICELINE.COM INC.
Priceline is a standout both because of its high valuation and the uncertainty of its name-your-price business model. Thanks to its William Shatner-narrated ads and successful March 30 IPO, the way Priceline works is by now quite well-known. Customers submit a lowball bid for, say, airline tickets, and if the seats are available, the sale goes through. It's a cheap way for airlines or other businesses to unload excess inventory like seats on a red-eye flight, so customers only interested in price can benefit. And Priceline has expanded into hotel reservations, home mortgages and cars.
Yes, it's a compelling model with real potential. The problem: As of July 1, the company's market capitalization was $15.2 billion, more than twice that of Delta Air Lines Inc. That's absurd, given how rough it is to compete solely on price in the Net marketplace. Even the biggest fans of Internet stocks would agree, contending that Amazon.com will succeed precisely because it doesn't compete on price alone.
Priceline's business, which has yet to stand the test of even Internet time, has somehow earned a large premium. Merrill Lynch & Co. analyst Henry Blodget, who is very bullish on Priceline, expects its revenue to be $450 million in 2000. By that measure, Priceline trades at 38 times 2000 revenue, while other e-commerce stocks trade at 10 to 20 times.
Another relevant statistic: Only about 35 percent of the bids Priceline deems "reasonable" actually result in sales. That means reliability isn't a selling point, a factor that makes competing on price even harder. Unlike Amazon.com, Priceline offers no first-class service or cachet on which to build brand loyalty. As Priceline expands into other markets, it will run up against other Net franchises competing on price, like Buy.com Inc. or Beyond.com Corp. So what's this company really worth? Name your price.
QUALCOMM INC.
Wireless communications provider Qualcomm only recently qualified for this list. The stock's ascent began on March 25, when Sweden's LM Ericsson Telephone Co. settled its patent dispute with the company and agreed to support Qualcomm's wireless phone technology. Ericsson also agreed to buy Qualcomm's money-losing wireless infrastructure unit. Over the next four weeks, Qualcomm's stock price soared 121 percent, as analysts' earnings estimates for 2000 rose just 50 percent. That means the price-to-earnings ratio on that number increased above 45. Qualcomm could well earn that high multiple over time, but investors ought to wait before adding this stock to the pantheon of superachievers.
SUN MICROSYSTEMS INC.
With its servers and software in wide use for Net-related businesses, Sun has successfully remade itself into an Internet player. But even though Sun may be the dot in "dot.com," it still isn't a dot.com stock. It's a hardware stock -- at least until it starts making significant money from Java -- so it should be valued as a hardware stock. When IBM Corp.'s forward P/E is less than 30, it's hard to justify Sun carrying a P/E of 40, twice its annual growth rate.
VALUE AMERICA INC.
Despite its name, Value America is the most expensive stock among the diversified online vendors that compete on deep-discount prices. BancBoston Robertson Stephens Inc. forecasts the company's gross margins (operating income as percent of sales) will be just 3 percent this year. By comparison, the firm estimates that Onsale Inc. and Egghead.com Inc., just to name two competitors, will have gross margins of 5 percent and 10 percent, respectively. Yet Value America's shares trade at roughly six times estimated 1999 revenue, more than double the multiple of either Onsale or Egghead.com.
YAHOO INC.
Yahoo is more than just the leading Internet portal -- it's one of the biggest brand names associated with the Internet. But its leadership position and the fact that it already earns a small profit has given its stock a premium valuation that's out of line with other portal companies. Analysts expect 2000 revenue of $625 million, which means it trades at 57 times revenue. By comparison, Lycos Inc. trades at roughly 21 times 2000 revenue, and Infoseek Corp. trades at 13 times. "[Yahoo] just gets a fantastic premium," says William Blair & Co.'s Gami. "It's off the scales on my methodology."
---
The 20 Most Inflated Tech Stocks Although most market players agree that technology stocks have achieved extremely high valuations, some contend it isn't so terrible. That's because it's all about growth.
Based on sales growth rates, the most expensive large-capitalization technology stocks are actually cheaper than the most expensive nontechnology stocks, says Huachen Chen, co-manager of the Dresdner RCM Global Technology Fund.
Compare the large-cap stocks. Microsoft Corp. and Cisco Systems Inc. both trade at a price-to-earnings ratio (P/E) that's roughly twice their growth rates. Meanwhile, Chen points out, slower-growing Coca-Cola Co. trades at a P/E of 40, which is two and a half times its growth rate.
Although Chen says he generally doesn't like to buy a stock with a P/E greater than its growth rate, he believes market leaders deserve a premium. He also notes that while the "megacap" technology companies often have a P/E that's twice their growth rate, the P/Es of midcap and small-cap tech stocks tend to equal their growth rates. "The market is saying there's a value to the brands built by these megacap companies," says Chen.
And the truth is that, the broad market has become historically expensive, so the high-valuation stocks have become even more so. That makes many moderately expensive technology stocks reasonably valued. For example, mainstream hardware stocks like Hewlett-Packard Co. may sell for 20 to 25 times forward earnings. But that's still a discount compared to the S&P 500, which trades at roughly 27 times forward earnings.
"When Coke and Gillette [Co.] sell for 30 to 40 times earnings with less growth, why shouldn't IBM [Corp.] sell at 30 times earnings?" says Steven Milunovich, an analyst at Merrill Lynch & Co.
"In technology, you're typically better off buying leadership stocks that are expensive," says Milunovich. Second-tier companies with cheaper stocks will have a tougher time competing, he believes.
The stock market runs in cycles, so this mania for high-valuation, megacap stocks can't last forever. Still, says Chen, "I try not to argue with the market in the short term." -- L.F. |
