FYI:
interactive.wsj.com
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Big-Cap Tech Stocks
Are a Sucker Bet
By Jeremy J. Siegel, a professor of finance at the Wharton School and
author of "Stocks for the Long Run" (McGraw Hill, 1998).
Until Monday's sell-off the Nasdaq Stock Market had enjoyed quite a
run, surpassing 5000 for the first time even as the Dow Jones Industrial
Average went through a correction. But are the high valuations of the tech
stocks that drive the Nasdaq index justified? History suggests not.
In the late 1960s Polaroid was at the top of its game, dominating the
photographic field and enjoying one marketing success after another.
Investors bid the stock up to an unheard-of 95 times earnings. Never
before had a large-capitalization stock been priced so high. But Polaroid's
earnings growth had exceeded 40% a year over the previous 14 years,
and the future seemed even brighter.
Most Valued Stock
IBM became the most valued stock in the world in 1967 and held on to
that position for more than six years. The dominant computer manufacturer
enjoyed enviable margins and virtually no competition. Its stock value
reached 50 times earnings, a striking multiple for the world's largest
company. But why not? IBM had regularly cranked out 20% annual
increases in earnings from the early 1950s, and the future obviously
belonged to technology.
Yet investors who purchased these and many other stocks when the future
looked brightest had much to regret. Polaroid faltered badly, and its stock
gave investors negative total return over the next 30 years. And despite
IBM's comeback under CEO Lou Gerstner, the company's return has
been less than half that of the Standard & Poor's 500 index over the past
generation.
These examples are typical. History has shown that whenever companies,
no matter how great, get priced above 50 to 60 times earnings, buyer
beware. A few stocks of the nifty-50 era subsequently outperformed the
market, but in that venerated group no stock that sold above a 50
price-to-earnings ratio was able to match the S&P 500 over the next
quarter century. Such great companies as Baxter Labs, Disney,
McDonald's, Johnson & Johnson, AMP and Texas Instruments have
trailed the averages.
Unsustainable Values
Large-cap companies with price/earnings ratios over 100
Company
Market
Cap
(3/7/00, in
bil.)
1999
P/E
Est.
Growth
P/E in 5
years
P/E in
10
years
Cisco Systems
$452
148.4
29.5%
73.9
40.9
AOL/Time
Warner
232
217.4
31.5
100.0
51.1
Oracle
211
152.9
24.9
91.3
60.5
Nortel Networks
167
105.6
20.7
74.5
58.4
Sun
Microsystems
149
119.0
21.1
82.8
64.0
EMC
130
115.4
31.1
54.0
28.1
JDS Uniphase
99
668.3
44.0
195.5
63.5
Qualcomm
91
166.8
37.3
61.8
25.5
Yahoo!
90
623.2
55.9
122.6
26.8
15 non-tech
2,361
30.4
13.7
23.8
20.3
S&P 500
11,281
28.6
12.5
23.8
21.3
Source: Bloomberg
But many of today's investors are unfazed by history -- and by the failure
of any large-cap stock ever to justify, by its subsequent record, a P/E ratio
anywhere near 100. As the chart nearby shows, of the 33 stocks (18 tech
and 15 nontech) that have a capitalization over $85 billion today, an
incredible nine currently have P/E ratios in excess of 100, and six of those
are in the top 20.
Supporters of these valuations point to their fantastic growth and rosy
prospects. And indeed, analysts' estimates of future earnings growth,
collected by the Institutional Brokers Estimate System, have predicted that
these stocks' earnings per share will grow more than twice as quickly over
the next five years as the S&P 500.
But once a firm reaches big-cap status -- ranked in the top 50 by market
value -- its ability to generate long-term double-digit earnings growth slows
dramatically. Schlumberger, an oilfield-service company, was alone when it
attained a 10-year growth rate of 35% in the 1970s, but no investor would
have been happy picking this stock at the height of its earnings growth in
1980. Merck has been able to reach 10-year earnings-per-share growth
rates near 20% in the 1980s. And yes, Microsoft has achieved a 10-year
growth rate in the mid-40s. But Microsoft did not reach big-cap status until
1993.
Even if the fantastic long-term growth rates IBES predicts for the tech
companies come true, they won't be nearly good enough to sustain current
values. I calculated what the P/E ratio of each stock would be, assuming
that these earnings estimates not only are realized in the next five years but
are even replicated in the following five. To determine the future price of
these stocks, I assume that investors expect to receive an average 15%
annual return on these highfliers. Given the volatility of these tech stocks,
this assumption is reasonable, and it is doubtless considerably less than
many investors expect.
The results are not comforting. Even if the earnings estimates are realized,
in five years the average P/E ratio of the "over-100 P/E" stocks drops only
to 88.6. And three (America Online-Time Warner, JDS Uniphase and
Yahoo!) remain over 100. If the IBES estimates for earnings growth can
be maintained for 10 years, the P/E of these stocks fall only to the mid 40s.
Even though these stocks will by then totally dominate the market, they will
be priced at twice the level projected for the S&P 500.
The 15 nontech stocks with market capitalizations over $85 billion look
like a much safer investment. I assumed a return of 10% per year, in line
with historical market returns. The current P/E of the big-cap nontech
stocks is currently just over 30, a bit higher than the S&P 500 (assuming
the same 10% return). And their projected earnings growth rate, at 13.7%
per year, is just above that of the S&P 500. In five years the P/E of
nontech stocks falls below 24, and in 10 years to just over 20 -- a very
reasonable P/E ratio considering the increased productivity growth and
stability of our overall economy compared with the historical record.
What does all this mean? Our bifurcated market has been driven to an
extreme not justified by any history. The excitement generated by the
technology and communications revolution is fully justified, and there is no
question that the firms leading the way are superior enterprises. But this
doesn't automatically translate into increased shareholder values.
Not From Sales Alone
Value comes from the ability to sell above cost, not from sales. If sales
alone created value, General Motors would be the world's most valuable
corporation. In a competitive economy, no profitable firm will go
unchallenged. Margins must erode as others chase the profits that seem so
easy to come by now. There is a limit to the value of any asset, however
promising. Despite our buoyant view of the future, this is no time for
investors to discard the lessons of the past. |
