I saw the link earlier, here's a pasted copy:
FOOL ON THE HILL
An Investment Opinion
by Louis Corrigan
Iomega's Downside Risk
Ben Graham, the father of fundamental analysis and value investing, understood that the safest way to make money in the stock
market was to avoid losing it. Graham was thus attracted to stocks that traded very close to their net tangible asset or book
value because, in his famous phrase, these issues provided a "margin of safety." But with the Dow hitting new highs, value
investors today appear to be a persnickety lot who can't find much to choose from among large-cap stocks.
Commentators have suggested that investors may be throwing money at well-known names with little pause regarding the risks.
While that may be the case, investors were emboldened this week after multi-billionaire investor Warren Buffett made some
relatively sanguine comments about valuations (with certain caveats). Buffett is Graham's great protege and completely
embraced the concept of a "margin of safety," but Buffet's departure from Graham's intellectual roots was marked by stricter
qualifications for what constitutes a quality business. Nevertheless, if this touchstone of avuncular wisdom now thinks "there is
no reason to think of stocks as generally overvalued" in light of the interest rate environment and strong returns on equity, then
maybe the kids don't have to end the party yet.
Even so, investors need a methodology for thinking about downside risk, in part because it's so tempting not to. Check your
own investment fantasies. You may have thought a lot about how much you could make on a stock and perhaps very little
about how much you might lose. The dangers of such wishful thinking hit home this week around the Motley Fool as removable
disk drive maker and Fool Portfolio stalwart Iomega (NYSE:IOM - news) zipped up an era of rising sales and burgeoning
earnings with a chilling announcement. The company now expects that flat sales and a pricey ad campaign will lead to a first
quarter loss of $10 to $25 million. This week's 17% drop to $7 1/8 completes a stunning 57% slide since last December and
leaves Iomega trading near its lowest levels since the shares went parabolic in the late spring of 1996.
How low can it go? Based on book value alone, the potential drop looks perilous. At the end of the fourth quarter, Iomega's
balance sheet showed shareholders' equity of $459 million. Shareholders' equity is often used as an easy proxy for book value,
but they can differ. The former is simply total assets minus total liabilities while the latter is total assets minus intangible assets
(such as goodwill or patents) minus total liabilities. In Iomega's case, shareholders' equity equals book value. Divide it by
Iomega's 283 million fully diluted shares, and you see the book value is just $1.62 per share.
Barring some major disaster, not even the Iomega bears think the stock will fall that far. Few computer-related high-technology
companies with any semblance of brand cachet, market strength, proprietary technology, or value-added manufacturing will
trade down to their book value. Their tangible assets are simply tiny compared to the intangible ones. Iomega has a well-known
brand, patents, and a dominant market position. International Data Corporation reports that Iomega has 87% of the low-end
removable data storage market thanks to the 100 megabyte Zip drive and 62% of the high-end thanks to the 1 gigabyte Jaz
drive. So book value alone won't cut it. So what might?
Michael Murphy, longtime editor of the California Technology Stock Letter, has proposed a three-part metric for valuing
high-tech stocks that he calls the Downside Risk Value (DRV). Murphy's methods should be of special interest to Iomega
investors since he's also editor of the Overpriced Stock Service. He says he shorted Iomega near its split-adjusted May 1996
peak of $27 and covered at around $10 in September 1996.
Designed to produce lowball estimates, Murphy's DRV is the average of three measurements. The first is sales per share, which
for Iomega is $1,740 divided by 283, or $6.14. For the second, he takes the book value per share and multiplies by 1.5. The
theory is that since so much of a technology company's value is not captured in tangible assets, its stock would be a real bargain
if it traded even close to its book value. For Iomega, that gets us $2.42 per share ($459 million/283 equals $1.62 times 1.5).
For the third measurement, Murphy takes the sales growth rate over the last three years times the trailing 12-month earnings,
and then divides by three. The PEG ratio assumes that a company is fairly valued when its price/earnings ratio is equal to its
short-term growth rate. So Murphy assumes a stock trading at a third of its recent growth is cheap. To get a more conservative
number for Iomega, Murphy would take last year's $0.42 in EPS and multiply by about 14.5 (a third of FY97's 43.5% sales
growth) to get $6.09 per share.
Add up these figures ($6.14 + $2.42 + $6.09) and divide by three, and you get a downside risk value of $4.88. (In a phone
interview at the end of a long day, Murphy came up with a DRV of $4.45 due mainly to a $4.53 per share value on the sales
metric, which looks wrong.)
Murphy is willing to pay up for what he calls great "Growth Flow" companies, those that show strong after-tax earnings plus
research & development spending per share. Buying a Microsoft (Nasdaq:MSFT - news) , for example, at just a 25% risk to
the DRV would be a steal, whereas you're more likely to have to pay 50% or more above the DRV. Yet in turnaround
situations, a stock may actually trade below its DRV, a level that implies Murphy's version of Graham's margin of safety.
Does this formula work? Murphy ran the numbers last year for Apple Computer (Nasdaq:AAPL - news) when the shares
traded at $17. He came up with a DRV of $31. The market was so discounting Apple's troubles that the stock actually needed
to rise 85% to get to its DRV. Though it fell even lower in the interim, Apple shares have since borne fruit, stretching to $26,
up 53%.
Three cautions are in order here. First, this example shows there's certainly no magic to the DRV -- the true downside risk may
be much lower! Second, a company's DRV is apt to fall if it's suffering declining sales and increasing losses. Apple's DRV has
now dropped to $20 even as the stock has flourished. If Iomega ends up reporting a string of losses, its shareholder equity and
EPS will contract, cutting its DRV.
Finally, unlike book value, Murphy's formulation remains unavoidably messy, a reasonable attempt to offer a shorthand, black
box means for thinking about value among high-tech growth stocks. In practice, assessing real risk involves making judgment
calls about issues such as the quality of management, the momentum of competitors, and the impact of shifts in the underlying
industry. All are relevant to Iomega's present troubles.
For his part, Murphy thinks it's unrealistic to expect Iomega will fall to his DRV target of $4.45. "I just don't see there's a lot of
risk in the stock [today]." But Murphy thinks that the rapid pace at which hard drive capacity has expanded has caught the
company by surprise. For Iomega to retain a broad market for its products among consumers looking for backup solutions, he
thinks the company must drive its technology faster. Of course, Iomega's plan to boost demand through increased ad spending
doesn't at all address this critique. |
