News Analysis & Commentary: Markets
Are High-Tech Stocks Headed for More Turmoil?
The recent rally may have shares overvalued again
Did tech stocks drop far enough last year to finally make them a bargain? Some investors clearly think so, because they're bidding prices right back up. Through Jan. 24, the Nasdaq Composite Index was up 15% in 2001, wiping out nearly a quarter of last year's horrendous 39% drop.
That may sound like great news. But the big leap may have pushed tech stock valuations back toward dangerous ground. On average since 1962, investors have been willing to pay about $33 per share for companies that earned profits of $1 per share the previous year. That's the average price-earnings ratio over the period for typical tech stocks tracked by Leuthold/Weeden Research in Minneapolis. After peaking last March at a stratospheric 115 times earnings, tech prices fell to a reasonable 38 times earnings at the end of December. But this year, they've spiked back to 48 times earnings, putting valuations nearly 50% above their long-term average.
As a result, some smart investors aren't convinced tech stocks have seen the bottom. Clipper Fund co-manager James Gipson, last year's Morningstar Mutual Funds manager of the year, thinks tech stocks are still overpriced. "A number of larger tech stocks are still valued at levels seen only in past bull market peaks," he says. Yahoo! Inc., he points out, trades at 84 times last year's earnings even after an 80% drop in stock price since last March. Cisco Systems has a p-e of 71, while EMC's is 100 and eBay's p-e is 225.TEETERING? Since most tech stocks pay little or no dividends, investors are buying them almost entirely for their potential growth in revenue and profits. That means prices are ultrasensitive to changes in projections of long-term profit growth.
Right now, many big names in tech look precariously overvalued in light of recent downward revisions in Wall Street's forecasts of their profit growth. One way to see this is with a widely used tool known as the dividend discount model. The model evaluates companies by their projected future profits. Future profits determine companies' capacity to pay dividends, whether or not they pay dividends now or have plans to do so.
The model factors in such things as interest rates, consensus analyst estimates of earnings growth, and a risk premium based a stock's volatility. One model supplied by Bloomberg Financial Markets shows what happens to tech stocks when investors lose faith in their growth outlook. (Bloomberg doesn't vouch for the assumptions that go into the model and lets customers change them if they disagree.)
When viewed through the lens of the discount model, Microsoft Corp. doesn't look like such a good buy, even though the stock has dropped by nearly half since last January. In fact, the discount model says Microsoft was still 38% overvalued at its Jan. 24 price of $60. The reason: analysts' long-term profit forecasts have slid from 24.5% in September to just under 20%. Investors reacted to those lowered expectations by driving the stock down to $40 in December, but it has since rebounded. If Microsoft's expected profit growth rate were to slip to 15%, the stock would be worth just $28 a share, according to the model.
Using the same methodology, the model suggests that a number of once-high-flying tech stocks remain overvalued: Lucent comes out 300% overvalued, Yahoo 120%, and Sun Microsystems 60%. And EMC Corp., one of the industry's most stable fast-growth companies, is overvalued by 15%.LITTLE FAITH. Of course, the dividend discount model doesn't always say tech companies are overpriced. Indeed, it calculates that AOL Time Warner, Oracle, and eBay are undervalued by 50%, 43%, and 49%, respectively. And some fast-growers are even more undervalued. Juniper Networks Co. is said to be undervalued by 69% at a recent price of $136. But beware: The model's key assumption is that Juniper's profits will grow an average of 57% a year for the next five years. If Juniper's projected earnings growth drops to 40%, the stock would be worth only $112--making it a "sell."
Some professional investors don't put much faith in the dividend discount model, arguing that it's better suited to valuing slower-growing companies. "Tech stocks tend to respond to shorter-term events, including the near-term predictability of earnings and how they make their earnings," says John H. Bogle Jr., manager of the Bogle Small Cap Growth fund. And many investors simply don't dare stay out of tech. "If you look at strong growth stories, they've gotten about as cheap as they're going to get," says Firsthand Technology Value fund manager Kevin Landis. He may be right. But any signs of slower growth ahead could quickly send them tumbling again--making them even bigger bargains.By Geoffrey Smith in BostonReturn to top