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Technology Stocks : DELL Bear Thread -- Ignore unavailable to you. Want to Upgrade?

To: Moominoid who wrote (2176)	10/19/1998 5:10:00 PM
From: Beltropolis Boy	Read Replies (2) \| Respond to of 2578

one man's opinion ... for the record, i'm not a bear. just thought the board might enjoy the read. ----- Morningstar.Net Stock Analyst's Journal By Haywood Kelly 19 October 98 Just how expensive is Dell Computer? Even at $57, almost 20% down from its peak, Dell's stock seems expensive. It trades for 63 times earnings and 5.5 times sales, or two to three times the average valuations for large-cap stocks. But there's a group out there who argue that Dell's a bargain. I don't completely buy their argument, but they raise some good points. Here's the argument. Dell earns an incredible 74% on its equity base, compared with an average for the S&P 500 of about 20%. Profitability that much above average easily justifies the stock's rich valuations. And that's just the beginning. As of last quarter, Dell carried $2.5 billion in cash on its balance sheet, compared with $1.6 billion in equity. That cash hoard disguises how profitable Dell's core business is. If we look at returns on Dell's fixed assets, which only total some $500 million, the company's ability to churn out profit is out of this world. It earns 250% on its fixed assets. In other words, for every $1 Dell has invested in assembly plants, warehouses, machinery, and so on, it's throwing off $2.50 in profit. Not even Microsoft can come close to these numbers. What implications does this have for Dell's stock valuations? To take Dell's incredible profitability into account when valuing its stock, we can make some simple adjustments to earnings. Let's charge Dell 10% for its equity capital, which is the rate on 30-year Treasury bonds plus a 5% "equity premium" to account for the fact that Dell's stock is riskier than Treasuries. Taking 10% of the company's shareholders' equity of $1.6 billion gives us $160 million, or $0.13 a share. Think of this as how much we're penalizing Dell for using as much capital as it does. We'll subtract this $0.13 a share from Dell's forecasted earnings per share next year of $1.40 to get a new earnings figure of $1.37. This is Dell's earnings adjusted for the cost of its equity capital. With a stock price of $57, Dell trades for 44 times its modified earnings per share. It seems steep, but it's really not. The average P/E for large-cap stocks in Morningstar's Principia database is 38. Compare Dell's figure with that of a company like Exxon. Exxon trades at a forward P/E of 25--one third the level of Dell. But if we adjust Exxon's earnings for the capital it's carrying, just like we did for Dell, we get a modified P/E for Exxon of 57. Quite a difference. The reason: Exxon is a capital hog. It needs a $1 in fixed assets to generate just $0.11 in profit. (Remember, Dell turned that same $1 into $2.50!) Taking into account the cost of equity capital, investors are actually paying more for Exxon's earnings than for Dell's. It's an alluring argument--that Dell's cheap because it's just so darn profitable--but there's one catch. It's premised on the assumption that Dell's high returns on capital will continue. As far as Dell's future stock performance is concerned, what matters is the return the company makes on the marginal dollar invested--the return on each additional dollar invested in the company. Suppose, for example, that Dell were to invest each new dollar at a return of 25%--a great return by just about anybody's standards. Its stock would plummet. (Conversely, if Exxon were to invest each new dollar at 25%, its stock would soar.) It's a little like the Yankees heading into the World Series. They won the most games during the regular season. Fine. But all that doesn't mean a thing anymore--winning four games before the Padres do is what counts. If the past were all that counted, and not the next (or marginal) win, the Yankees would already be sporting their championship rings. So yes, Dell's stock price is reasonable if the company can maintain--or come close to--its current level of profitability. But look out if those marginal returns on capital start to come down significantly. Remember, returns on capital tend strongly to regress to the mean; competitors like Compaq are only too willing to see to that. And because marginal rates of return can drop so steeply, so rapidly, it's always dangerous to bet they'll continue at current levels, particularly if current levels are grossly abnormal. That's why regardless of its super profitability in the past, Dell is still a very expensive stock. Haywood Kelly is Senior Writer for Morningstar StockInvestor. If you've got thoughts or questions about this column, you can send him an e-mail at hkelly@morningstar.net. morningstar.net