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8/1/2003
01:51 PM
William Schaff
William Schaff
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Taking Stock: Measure Carefully To Gauge Stock Value

The moral of the story: Valuing tech stocks is a treacherous affair.

Valuing technology stocks has always been more of an art than a science. When is a stock truly cheap? Are tech stocks expensive when they look expensive, or is there some twisted logic at work obscuring whether a stock is a bargain or overpriced?

There is, of course, no one correct way of valuing stocks. If that were the case, the stock market wouldn't move up and down the way it does, as all investors would agree on the correct valuation immediately. I use yardsticks such as price to earnings, price to book value, price to sales, or even cash per share in attempting to value tech stocks. The most commonly used measure in the stock market is price to earnings, which shows the ratio of the stock price relative to the company's earnings per share. For instance, eBay is trading at a price to earnings of 72 times the 2003 consensus earnings forecast, meaning that eBay's stock price of $108 is equal to 72 times the $1.50 per share that analysts expect eBay will earn in '03. Another way to look at eBay's valuation is to divide earnings by price, a.k.a. earnings yield, which in this case results in an earnings yield of 1.4%. In other words, an investment in eBay would potentially give you a return of only 1.4%, little more than a savings account. EBay's stock price is up 105% since Sept. 30, 2002, contributing to the high valuation.

Let's look at Texas Instruments, which in comparison is up only 28% since Sept. 30, 2002. The company is one of the largest makers of semiconductors, and it was hit hard by the downturn in the telecom sector. Revenue declined almost 30% between 2000 and 2002, and earnings per share went from $1.72 to a loss of 20 cents per share. TI is trading at 57 times the '03 consensus earnings-per-share estimate. However, the story is very different from that of eBay. EBay continued to increase revenue and earnings throughout the downturn. TI saw revenue decline, and it was saddled with semiconductor fabrication plants that were underutilized. As revenue increases, the company's gross margin should improve dramatically and earnings per share should grow much faster than revenue. This is the nature of highly cyclical companies. For TI, using a price-to-earnings multiple may not make much sense with earnings at somewhat depressed levels as the company enters the recovery phase of its business cycle.

Juniper Networks straddles both camps. The company went through a steep downturn as demand for routers vanished, and the next victim was earnings. However, the stock is up 196% since Sept. 30, 2002, and never got really cheap, in my opinion. It's trading at 142 times the '03 consensus earnings-per-share estimate, which looks a tad rich for me, even though earnings are depressed.

Valuing tech stocks is a treacherous affair. Using one yardstick all the time may lead to incorrect conclusions about whether a stock is cheap or overpriced. Sometimes price-to-earnings multiples will give the right answer, while other times price-to-book multiples will point investors in the right direction.

William Schaff is chief investment officer at Bay Isle Financial LLC, which manages the InformationWeek 100 Stock Index. Reach him at bschaff@bayisle.com. This article is provided for information purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any security. Bay Isle has no affiliation with nor does it receive compensation from any of the companies mentioned above. Bay Isle's current client portfolios may own publicly traded securities in one or more of these companies at any given time.


To discuss this column with other readers, please visit William Schaff's forum on the Listening Post.

To find out more about William Schaff, please visit his page on the Listening Post.

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