RE: Valuations...
Kumar asks:
Mike & Bruce, I have read your posts on this topic. Appreciate the thoughts. I have 1 question, I am still unable to explain to myself :
As I understand it, most valuation metrics are derived from earnings and growth projections, typically upto about 2 years out from now.
If I want to buy into a chosen Gorilla, with the intention of holding on to it for a lot longer than 2 years (until a discontinuous innovation unseats the Gorilla), to what extent is current valuation important in my purchase decision ?
Most are unwilling to go out beyond a 2 year projection and many are only comfortable with a shorter time frame than that. Hence, we see the 12 - 18 month 'price targets' which in some cases are based on those figures. It doesn't mean if an analyst places a 12 month price target of a company that when the 12 months are up and the target is reached they would recommend selling the equity. Rather, they would calculate out another 12 - 18 months based on all the ingredients at that point in time. At various times within that 12 month time frame, you will see revisions based upon the quarterly reports from companies surpassing or falling short of expectations. Or if expectations are met, most would reiterate their price target so to speak. If a company was able to exceed expectations four quarters in a row, you can see how the comfort level of predicting two years out and beyond would keep an analyst from trying to use an accurate forecast of a 5 year period with any sort of confidence that would be of benefit to investors. Some analysts even break it down into six month periods which in my opinion really defeats the purpose of investing and leans more to short/intermediate term trading or at best, indicates that the recommendation from said analyst is that valuation concerns would prevent adding the equity at that particular point in time.
Although at $80 a share recently, in my opinion, Cisco would fall into the category of a Gorilla one would certainly want to own for longer than 2 years from this point going forward. Obviously the valuation at the higher price was a concern as it now sits at $57 a share. However, even at $57, the P/S ratio and P/E ratio puts it in a category that is far different than Microsoft, Intel, Qualcomm, Siebel or Oracle. Is there an explanation as to why the valuation for Cisco sits at this level?
We could make the argument that the technology adoption life cycle of IP/Broadband that is in its infancy is indeed justification for Cisco since they are most likely going to be smack in the middle of that life cycle as well as their accomplishments in the enterprise networking technology adoption life cycle. We could make the argument that the growth rate for Cisco compared to mature gorillas like Intel, Microsoft and Oracle justifies the higher ratios. We could argue that the history of execution by Cisco's management team justifies the current valuation because if they have proven anything in the past, it is that their unique model can and will execute. We could argue that the 'vision' element which permeated the market over the past 6 to 8 months was extended into the Gorillas as well. There a lot of things to weigh when considering the valuation. Not only pure YPEG and shorter term growth projections, but the premium for the CAP that the market has awarded Cisco over the past year. Believe me, there have always been valuation concerns since 1990 for this company and yet - what a performer.
The same could be said for Microsoft, Intel and Oracle. Valuation concerns, upgrades, downgrades and price targets throughout their life have been the norm in the financial industry. Yet, at the heart of gorilla gaming, is the fact that these companies have shown that regardless of the short/intermediate term valuation concerns - the longer term has proven to reward the investor. This is not to say that valuations should not always be a concern along the way. If not - the ratios would run out of sight and the share price would get way ahead of the growth rate causing the market to 'not be in check'. Even if one had purchased at the height of valuations along the way for these companies, the longer term has proven that eventually the revenue and earnings growth of the company will 'catch up' to the valuation paid. The question is what the long term effects are for an investor that pays 'too much' to one that pays 'not so much' for the investment.
Because of such concerns, strategies such as dollar cost averaging help to provide the investor with a more 'average' valuation over a period of time. I'm not saying that is the best strategy, but it is one that many investors adhere to and meets their criteria.
The market moves over the past 6 to 8 months seem to be a classic 'is everything in check' created correction that was fueled by nervousness of the momentum, interest rate concerns, economic cycle concerns, speculation and pure valuation concerns. Although it appears painful, this is how we want the markets to behave. We want efficiency. It doesn't mean we are 'off to the races' again, but it does mean that a lot of cash on the sidelines will eventually be put into investments that will provide a rate of return far better than what it can obtain in cash or fixed income vehicles. Call it efficient markets, a return to normal valuations or whatever you want to call it. However, it has happened before and will happen again.
Therefore, it is a perfect time to be looking at valuations and the best place to have one's money invested for the next few years. How do the valuations of companies like Cree, Echelon, Redback, i2, Ariba, Exodus, Brocade, JDS Uniphase, Rambus, Gemstar to name but a few we have discussed compare to the valuations of companies like Cisco, Intel, Microsoft, Qualcomm, Oracle, Siebel, EMC and Sun Microsystems? How do all the valuations today compare to a week or month or two ago?
Some have already reported for the most recent quarter while others are coming up. Looking at these reports is a nice way to get a snapshot into the current efficiency of all the companies, but it is only one quarter which we use as a 'check up' measure in the life of the company. Most likely, we will see that these companies are all performing quite well. The rise in equity prices and current correction has not changed that at all.
That being said, even if one is a valuation 'junkie', there is a lot of vision or speculation on what the future will bring in for our gorillas and other investments. I can be pounded over the head by fellow investors who argue with me about a financial stock that is trading at 'only a P/E of 6' or 'the P/E is at a very reasonable 12'. Yet, if I calculate out all the scenarios for those companies I can draw a conclusion that there is a reason they are trading at those multiples now and there is a reason they will most likely be trading at those multiples one year, two years, three years and even longer into the future. Will a Microsoft which has a current P/E of 50 and a P/S of 17.1 reward me more than one of those financial stocks at the low P/E multiple? Knowing the growth criteria that Microsoft meets, I like my odds. Will a Qualcomm offer the same? I like my odds. Will I still be arguing with those investors a few years from now. I like my odds.
BB |
