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What's a Stock Worth?

What's a stock worth?

July 7, 2000

6 Min Read
What's a Stock Worth?

What's a stock worth? It's no different than valuing a car. You've got to kick the tires, check out the market rates, and make a personal judgement about how much you're willing to pay.

On Nasdaq, valuation metrics for technology stocks--and especially optical stocks--have swung dramatically in the last year, and investors are readjusting their tolerance for valuations that have risen and fallen according to the the whims and fads of the crowd at large. The market's reality check in the spring appears to have brought people back to more reasonable methods of valuing a company and a stock.

Everybody has their favorite way to value a technology stock--there are price/earnings ratios, price/sales ratios, and then ratios made of the ratios themselves. For example, a common method is to take the price/earnings ratio--which divides the price per share of a stock by the annual per-share earnings--and then divide that by the annual growth rate of a company. With this formula, you come up with a ratio commonly referred to as the PEG. The PEG of a technology stock usually falls between .5 and 3, with .5 being very cheap and 3 being very expensive. As I mentioned in an April column on Redherring.com ("The New New Rules,") there was a point during the manic bull run when valuation metrics for emerging technology companies were thrown out the window. People were willing to pay anything for a stock, no matter how fast it was growing and what the market potential. But it's essential to remember that the stock market exists for a reason--to place a value on a company--and such valuations factor in many uncertainties: potential growth of the market, belief in the management's capabilities to beat the competition, and the assumption that certain economic or finanical "disasters" won't happen.

"We always try to buy growth at reasonable prices," says Erik Weir, president and CEO of Weir Capital Management. "We had to pay more than we wanted for the last couple of years. But things are more reasonable now." In certain cases, Mr. Weir uses P/E and the P/E-to-growth ratio (PEG). For example, his fund recently took a position in Polycom (Nasdaq: PLCM), which makes audio and videoconferencing systems, because it was growing at a 42 percent rate annual rate and was trading at a forward 12-month P/E ratio of about 70. Traditionally, investment managers have looked for stocks whose P/E ratios are close to their growth rates--when the P/E ratio floats significantly higher than the growth rate, the stock starts to become expensive. In Polycom's case, Mr. Weir points out that the company regularly beats earnings by about 15 percent, so he believes the actual earnings growth rate of the company is closer to 55 percent, which gave it a PEG of about 1.2 when he made the buying decision.

Mr. Weir likes to look at high-growth companies with PEGs in the 1.5 range, and he believes that the valuations are more sensible these days. "It's easier to find bargains," he says.

A P/E ratio works good for a maturing technology company with earnings, but what about a cutting-edge company that has yet to show a profit? That's where the price-to-sales ratios come in. The price/sales ratio divides the market capitalization [market value] of a company by its projected annual revenue. In the emerging Internet companies, these ratios can balloon into the hundreds, primarily because the market sizes are assumed to be huge and the companies are only in their embryonic stages of growth. In the private equity market, where estimated future price/sales ratios are used to caculate the valuation of a company, it's more typical to find price/sales ratios for technology companies ranging from 5 and 20, depending on the sector.

For example, if you look at the networking sector, you see emerging optical networking companies with higher price/sales ratios than the more established companies. That's because of the fundamental belief that the new companies can sustain higher growth rates. To give one example, Sycamore Networks Inc. (NYSE: SCMR), which has reported roughly $107 million in revenue over the last 12 months, is trading at a market cap of about $27 billion. That gives it a price/sales ratio of roughly 240-to-1. Yes, that's high. Compare that to Ciena Corp. (Nasdaq: CIEN)--a company that has booked much higher sales and actually earns a profit. Ciena has booked $606 million over the last four quarters, and it's trading at a market cap of $23 billion, giving it a price/sales ratio of 38-to-1. In other words, even though it's sold six times as much product as Sycamore, it's trading at a much lower multiple--and its market value is less than that of Sycamore. What does it tell you? Sycamore investors are willing to pay a lot for a stock on the bet that Sycamore's higher growth rate will someday make it a larger company.

As in the aforementioned example, you must look at a company's valuation in the context of a specific market. For example, a company in the networking hardware sector is going to have a higher price-to-sales ratio than one in the desktop software market, because the market for networking hardware is growing faster. You have to look at the the leaders in the market, and then compare the prices of these companies among the competition.

"When I use price/sales ratios, what's really important is the comparison to its peers," says Mark Morris, president of Internet Asset Mangement AG (iliefund.intnet.mu), a manager of Internet infrastructure funds based in Zurich. "I have a price/sales maximum of 200."

But Mr. Morris adds that he only expects such eye-popping valuations in young, smaller companies in emerging markets. For example, he prefers companies with less than $20 billion in market capitalization to giants with $200 billion market caps. "I'm looking for high growth. The best is to find a company that's [valued] at $3 billion to $5 billion that can run to $20 billion."

Indeed, this range seems to be a sweet spot for aggressive technology investors. Take a look at a Rambus Nasdaq: RMBS), Micromuse(Nasdaq: MUSE), or Redback Networks Inc. (NYSE: SCMR)(Nasdaq: RBAK) and you will find they made their big moves when they fell near this $5 billion sweet spot. In all these cases, there were earnings or technology breakthroughs that gave investors reason to start piling in. As soon as their share prices have grown beyond a $10 billion market cap--as is already the case with Redback--powerful growth becomes more difficult to sustain.

How would number-crunching have helped you in these scenarios? The rallies in each of these stocks started when they got beaten down to more reasonable levels of valuation--and then good earnings news and emerging technology developments signaled that it was time to buy.

In other words, you have to wait and pay what you want for the car, not necessarily what the dealer is asking.

by R. Scott Raynovich, Executive Editor, Light Reading (http://www.lightreading.com)

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