Sometimes the debate gets hackneyed: The Valuation Curmudgeons decry the "astronomical" market valuations of technology companies; and New-Age Prophets proclaim that the advent of the "New Economy" is the harbinger of Utopia.
You could basically break the debate into two separate camps: The Fundies, who believe that nothing has changed about valuation methods and that technology companies should be valued based on the same fundamental methods that were used to evaluate large industrial concerns 50 years ago; and the Knowledge Capitalists, who largely believe in the efficient market theory -- which says that the market always sets the right price -- and that fundamental changes in the economy dictate that we use new valuation methodologies for fast-growing technological enterprises.
The truth, as usual, probably falls in between. But the world has changed, and the Fundies have clearly been in denial. Technology stocks have a premium built into them because they represent the fastest growing, most efficient sector of the economy at large. In many cases -- especially areas such as networking hardware and software -- such companies have employed outsourcing models that greatly diminish the need for capital expenditure, and they can therefore invest capital in more rewarding areas such as research and development (R&D). These same factors, of course, lead to volatility. As soon as a fast-growing research-oriented company stumbles, the rug can get pulled out from under its share price.
"All valuation tools that rely on traditional accounting methods are misleading investors in this period of rapid change," says Andre Desautels, a CFA and analyst at Trilogy Advisors, an investment firm that manages CI funds, a set of Canadian mutual funds.
A recent interview with Desautels confirmed many of my suspicions about the market. It was comforting to find a qualified CFA to scientifically explain what I'd intuited. You cannot value a company simply by looking at the quarterly earnings. There are hidden values in companies that don't turn up in the financial profiles.
These are often referred to as "intangible assets," and Mr. Desautels believes they explain the seemingly high valuations of many stocks. For example, in the Old World, R&D expenditures are accounted for as an expense, where in the New World you should account for R&D as earnings re-invested in the company, rather than lost expenses. Think about it: Would you rather have a company that's earning a dollar per share and re-investing none of that money in R&D; or do you want to hold onto a technology company that reinvests 25 cents of every dollar of earnings back into R&D?
The official accounting term that applies to such intangible value is "Goodwill," but goodwill often falls short in explaining how valuable a company is. Another huge, intangible value lost in conventional models is the value of management expertise. If you think about the most well-managed companies in technology, they have been constantly underestimated over the years because traditional accounting menthods have discounted the hidden value of their superior management. Think about Cisco (Nasdaq: CSCO): How many times during the company's lifetime have we heard the curmudgeons moan about the overvalued price/earnings ratio on Cisco stock? Well, consistently, Cisco's management team and its well-oiled acquisition machine has proven traditional assessments wrong. It is now one of the three most highly valued companies in the world. It has been Cisco's management team and acquisition process that have accounted for the premium on the stock, not some kind of misguided investor bubble.
Baruch Lev, a professor at New York University's Stern School of Management, has studied this phenomenon extensively, and he has come up with a term to describe it: "Knowledge Capital." Lev actually assigns a value to knowledge capital, which includes items such as the management team, the quality and number of patents and technology, and the skill of the engineering team. For example, he assigns the value of $210.9 billion for Microsoft's (Nasdaq: MSFT) knowledge capital. That's $210.9 billion in value that would be largely ignored by traditional accounting. Cisco's knowledge capital is valued at $105.4 billion, and Intel's (Nasdaq: INTC) at $170.5 billion.
That's not to say that no technology stocks are overvalued -- but the performance of the leaders seems to be consistently underestimated. The valuation curmudgeons have constantly missed the boat on emerging market leaders that were considered overvalued by conventional means; most likely, it's because they have consistently undervalued a company's knowledge capital at an early stage of its growth. Some examples in just the last two years include Juniper Networks (Nasdaq: JNPR) and Brocade Communications Systems (Nasdaq: BRCD). The people that dug down deep into the respective markets of these companies understood how powerful each of these players was in their respective emerging markets and recognized the knowledge capital embedded in the organization. Was there ever a time to get them at the right price? That's always hard to nail down -- but buying such companies on the periodic dips has been a golden strategy.
So, under this premise, what are knowledgeable capitalists such as Trilogy holding? Desautels still believes storage and networking technologies hold promise for the long term. Some of the long-term core holdings of his fund include Brocade, EMC (NYSE: EMC), Network Appliance (Nasdaq: NTAP), Nortel (NYSE/Toronto: NT), Juniper, and JDS Uniphase (Nasdaq: JDSU).
-- R. Scott Raynovich, executive editor, Light Reading http://www.lightreading.com