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Stocks: Are You Expecting Too Much?


Investors often accuse Wall Street analysts of inflating earnings estimates to hype stocks. But guess what? Investors are guilty of outrageous expectations, too. Just look at Vitesse Semiconductor (VTSS), the telecom-chip maker: Analysts estimate a 33.1% annual growth rate for the company's earnings for the next five years. But if you run the stock through a complex valuation model that incorporates earnings, stock prices, volatility, and interest rates, Vitesse's current share price of $12.47 assumes that earnings will grow at a hefty 56.1% a year over the same period.

Nor is Vitesse the only company for which investors have set such a high hurdle. We examined all of the companies in the Standard & Poor's 500-stock index with the same valuation model, and the results are eye-opening. Twenty of the companies have expected annual earnings-growth rates in excess of 40% priced into their shares (table); 81 have expectations of 20% to 40%. In total, investors are anticipating that nearly 300 of the 500 will experience annualized double-digit earnings growth over the next five years. Is that realistic? By the bull market standards of the 1990s, yes. By historical yardsticks, it's a stretch. Earnings growth for large-capitalization stocks has averaged only 4.75% a year from 1926 through 2000, according to Ibbotson Associates, a Chicago-based investment-research firm.

The growth rate incorporated into a stock price--known as the "implied growth rate"--is useful for evaluating a stock's prospects. We derived these growth rates from the dividend discount model (DDM) designed by Bloomberg Financial Markets for institutional investors. Investors typically use DDMs to estimate what a stock's price should be given its estimated earnings growth rate, its volatility, and current interest rates. But we turned the model on its head. We started with the current price and then worked backward to figure out what the growth rate should be to justify this price. That's the implied growth rate.

Results from a DDM can sometimes be misleading because they're dependent on certain assumptions. The model compares the estimated growth rate and historical volatility of a stock to the yield and volatility of long-term Treasury bonds. Since financial theory holds that investors need to be compensated for the risk of owning stocks, technology and other volatile stocks generally wind up with higher implied growth rates than low-volatility stocks, such as utilities. For instance, shares of semiconductor maker Applied Micro Circuits (AMCC) are almost three times as volatile as the average U.S. stock, so its implied growth rate is high to reward investors for the added risk. Yet if analysts' earnings estimates prove to be too low or the stock suddenly becomes less volatile in the future, then the DDM model's calculations will be wrong.

Supposing the DDM's assumptions are correct, you can then ask, for example, whether Applied Micro Circuits can really grow at its implied growth rate of 60.7% when analysts are estimating 36.9%. If you think the answer is yes, the stock is a buy; if not, stay away. Christopher Wolfe, an equity strategist at J.P. Morgan Chase, is a nonbeliever. "Applied Micro Circuits is a struggling midsize company in a very competitive industry," he says. "It's inconceivable that it will hit the growth rate built into its stock price."

DDM assigns the highest implied growth rates to technology and telecommunications companies because they have several strikes against them: Their earnings are either depressed or nonexistent, and their shares are extremely volatile. Most have had a good runup off their bear market lows, and their prices already reflect a lot of good news that may or may not happen. Some of the higher-priced ones include Palm (PALM), with an implied growth rate of 88.6%; AT&T Wireless (AWE) at 58.1%; and PMC-Sierra (PMCS)at 51.0%.

The DDM can also spot cheap stocks. They're the ones with extremely low implied growth rates, such as old-fashioned electric utility stocks, including First Energy (FE) and DTE Energy (DTE), which pay high dividends and are not very volatile. The implied rate is so low because much of the return is going to investors in the form of dividends.

Even if stocks look cheap, investors can't buy blindly from a model-driven list. Cyclical companies such as Ford Motor (F), U.S. Airways (U), General Motors (GM), and Dow Chemical (DOW) all show up now as cheap, but you need to ask plenty of questions. "A lot of stocks are cheap because they should be," says Raymond McCaffrey, portfolio manager of PBHG Large Cap Value Fund. "General Motors is a slow-growing stock with tough competition and labor issues. Dow Chemical has an asbestos liability against it."

Since we put the entire S&P 500 through the DDM, we also took a look at the very largest companies to see how they stack up. According to the model, General Electric (GE) has an implied growth rate of 14.8%. Although Wall Street analysts say the company can exceed that number, you should take that analysis a step further. In the past 12 months, GE has delivered $127 billion in revenues and $13 billion in profits. Analysts estimate GE's earnings will increase 15.5% a year for the next five years. But maintaining that growth rate will be an enormous feat. Other blue chips with high implied growth rates for the next seven years include giant retailer Wal-Mart Stores (WMT) (20.3%) and insurer American International Group (AIG) (15.6%).

As with any investment tool, professional investors don't all take the same view of the usefulness of a DDM or of calculating implied growth rates. Edmond Choi of Grantham, Mayo, van Otterloo, a Boston investment-management firm, says he doesn't think the DDM is good for projecting values of individual companies, but he does believe it works well for ranking stocks within a group or index to identify the relative values among them. So even if the tech stocks in our table don't have implied growth rates exceeding 40%, relative to other companies in the S&P 500, they still look expensive. That should be enough of a concern for investors to stay away. By Lewis Braham


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