>>
Boston, April 15 (Bloomberg) -- About 90 percent of this year's biggest winners in the stock market are Internet stocks.
Just as every investor had to decide a few years ago what to do about Japan (then the hottest market going), every investor today has to decide whether to try to ride the Internet mania, or to sit it out.
To do a dispassionate analysis is hard. These stocks not only flout conventional valuation yardsticks, they're in an emerging industry that's changing every day.
In an attempt to bring some rationality to the discussion, David Dreman and Eric Lufkin recently performed an analysis on 10 leading Internet stocks. Dreman is the chairman of the firm I work for; Lufkin is a senior vice president and quantitative analyst. In effect, they created a telescope through which to view those sky-high Internet stock valuations.
Their methodology was presented to a conference last week on ''Investment Decisions and Behavioral Finance'' sponsored by Harvard University's John F. Kennedy School of Government in Cambridge, Massachusetts. If you're an experienced stock analyst, the method may seem familiar because it's based on the old ''dividend discount model'' for valuing a stock. It doesn't deal with dividends, though, only with earnings.
Of course, many high-flying Internet stocks have no earnings to show, at least not yet. For those companies that are currently profitable, Dreman and Lufkin began their analysis with reported earnings. If there were no earnings yet, they used estimated earnings for the first year in which analysts expect the company to make a profit.
Fast Pace
Now comes the interesting part. The researchers assumed that those earnings will grow at a steady -- and very fast -- pace: They projected that earnings would grow 50 percent a year for the first three years, then 25 percent a year for the next five years, then 20 percent a year for the next six years. On top of that, they assumed 15 percent growth for seven more years, and 7.5 percent annual growth thereafter.
After hypothesizing what earnings will be in years to come, the two analysts assigned a present value to the earnings, discounting the future earnings stream back to the present at a 15 percent annual rate. (That represents the current Treasury bond rate of close to 6 percent, plus a ''risk premium'' of about 9 percent. The risk premium represents the minimum return above Treasury bonds an investor demands to take on the risk of an equity investment. It's probably safe to assume that Internet investors expect to make at least 15 percent return a year.)
Results
By this method, eBay Inc., the No. 1 online auction house, was the most overpriced of 10 leading Internet stocks examined. It was worth $6 a share, though it sells for about $165.
Next most overvalued was Yahoo! Inc., which was calculated to be worth $15 a share. Yahoo, the leading Internet search service, goes for about $183.
America Online Inc., the biggest online service provider, came next, with an estimated value of $30 and a stock price of $141.
Qwest Communications International Inc., Lycos Inc., and Excite Inc. all sold for a little more than twice their theoretical value under the model. E*Trade Group Inc., Ameritrade Holding Corp. and Amazon.com Inc. sold for roughly 33 percent more than their theoretical value.
Cisco Systems Inc., which isn't a pure Internet play, had a theoretical value of $118 under the assumptions. That is almost exactly Cisco's price of $118.81 when the calculation was done. Today, it trades at $108. Cisco is a more mature company than the others. It's therefore harder to imagine that its profits will grow at the rates postulated.
Fair Assumptions?
The question screaming for an answer is what to make of the growth assumptions posited in the study. Are they realistic? Are they too stingy for these bright new stars of the investment firmament? Or are they, perhaps, wildly optimistic?
You could argue that Dreman and Lufkin are being too conservative in assuming 50 percent earnings growth for the first three years that these companies operate in the black. It's possible that growth coming off the launch pad could be even faster than that.
Still, on balance, I think its clear that Dreman and Lufkin are leaning way over backwards to give these Internet stocks the benefit of the doubt. They're assuming 21 straight years of earnings growth that's not only fast, but uninterrupted.
No previous crop of red-hot growth stocks has achieved the kind of spectacular growth, year after year, that's being imagined here. It didn't happen with Japanese stocks, or biotechnology stocks, or bowling stocks, or television stocks.
'King of Stocks'
In fact, the only stock I can think of that might be able to live up to the study's heroic assumptions is Microsoft Corp. It achieved earnings growth of 75 percent in 1990, 67 percent in 1997, 43 percent in 1991, and has had at least 20 percent growth in each of the past 11 years. Truly, Microsoft deserves the title some have given it, the king of stocks.
To achieve the postulated level of growth, Microsoft would need to boost earnings at least 15 percent each year for another decade. The bigger you are, the harder that becomes.
In a separate and earlier study, Dreman and Lufkin calculated the odds of a stock's going 20 quarters -- five years -- without a negative earnings surprise. It was one in 6,000. That includes any instance in which earnings come in 5 percent or more below the analysts' consensus. Would a 5 percent shortfall be a mild surprise? Sounds like it, but popular stocks are taken out and shot for shortfalls even smaller than that.
Overall, the type of sustained, fast earnings growth the Dreman-Lufkin study talks about is virtually impossible to achieve. That of course, is precisely Dreman and Lufkin's point.
And even if you assume that such uncanny growth is achievable, most of the leading Internet stocks are still overvalued.
Apr/15/1999 12:45
<< |
