from canada;s report on business magazine...remember prices are in canuck $
After the bubble bursts: Are Nortel and other tech stocks a good value now?
By Stephen Foerster
May 1st, 2001
We have recently witnessed the gravitational forces of nature applied to technology stocks. The Nasdaq Composite Index soared from a level of 2,000 in mid-1998 to 5,000 in March, 2000, before falling back below 2,000 this past March. The price of Canada's darling stock, Nortel Networks Corp., rode the wave, climbing from below $20 on the Toronto Stock Exchange to over $120 in July, 2000, then crashing back below $25 this year. Should we have foreseen the bursting of the bubble? More importantly, are Nortel and other tech stocks now reasonably priced?
One of the most articulate warning shots was fired in 1999 when Anthony and Michael Perkins of Red Herring magazine published the book The Internet Bubble: Inside the Overvalued World of High-Tech Stocks--And What You Need to Know to Avoid the Coming Shakeout.
The book included an analysis of 133 publicly traded internet companies, each with a market capitalization of more than $100 million (U.S.) as of mid-1999. The Perkinses attempted to calculate the average annual growth in revenues each of those firms would have to achieve over the course of the next five years to justify those then-lofty market caps.
Based on some reasonable assumptions, they concluded that the average annual revenue growth for those firms would need to be around 80%. For some companies, such as eBay Inc. and Yahoo Inc., the implied growth rate was 150% to 170%. By any standards, those hyper-growth rates are not typical and have rarely been experienced, even among the most promising of early-stage growth companies. For example, in the first five years after Microsoft Corp.'s IPO in 1986, the company posted average annual revenue growth of "only" 53%.
In retrospect, those tech stocks were clearly overvalued in early 2000. Of course, many investors threw caution to the wind, and paid dearly for doing so. Perhaps Nortel was overvalued at $80, but why not buy it if, according to the "greater fool" theory, someone may soon be willing to buy it for $90, $100 or $110? Traditional valuation techniques that relied on projected earnings and cash flows were often nowhere to be seen.
The intriguing question now is: Is Nortel a buy? Let's compare Nortel in mid-2000 when the stock was selling for around $120 and had a market capitalization of $366 billion, with its recent value of around $28 and a market cap of $89 billion. Based on the Perkins valuation method, let's assume investors were pricing in a hyper-growth in Nortel's revenue for the next five years.
At the end of that period, assume investors expected Nortel to be selling for a healthy price-earnings (P/E) multiple of 40. Also, assume the company needs to earn a net profit margin of 10% on revenues, and that investors expected an annual return on their investment of 15%. Finally assume, like many tech firms with generous employee stock options for their executives and employees, a dilution in Nortel's equity base of 5% over the five years.
Based on these assumptions and applying the Perkins model, in mid-2000, Nortel investors were pricing in annual growth in revenues of 38% over the following five years. Based on a more conservative, expected price-earnings multiple of 25 times (closer to the average market multiple today), the implied revenue growth rate was 51%--very similar to the spectacular growth in the early days of Microsoft. Given that Nortel is a very large company in a mature market, that 51% annual revenue growth was extremely optimistic. No wonder some commentators said last summer that Nortel's stock was "priced for perfection."
So what is Nortel's implied growth rate now? With the stock price recently near $28, the company's market capitalization was about $89 billion. Its total revenues for the year ended Dec. 31, 2000, were $45.4 billion. Again, if shareholders require a 15% annual return on their investment, Nortel would need to grow to a market cap of $179 billion in five years, or $188 billion if you factor in a 5% dilution. Assuming a high price-earnings multiple of 40, five years from now Nortel's profit would have to reach $4.7 billion, and assuming a net profit margin of 10%, its revenues would need to be $46.9 billion. That revenue figure is similar to Nortel's revenues last year, so the company could meet investor expectations even if annual revenue growth was zero.
Assuming a more conservative P/E multiple of only 25 times, Nortel's implied revenue growth rate is 11% per year. Growth of between zero and 11% is much more realistically achievable than the implied growth rate of 38% to 51% just a few months ago.
Markets have a tendency to overreact on the upside and the downside. While we may not have hit the bottom of the tech market, current prices reflect a more reasonable outlook than the frenzied expectations of last year. If Nortel can achieve annual growth of 20% per year for the next five years, and eventually reach a net profit margin of 10%, then a price today of $40 would be justified. |
