Big-Cap Tech Stocks
Wall Street Journal, March 14, 2000
|Company||Market Cap (3/7/00, in bil.)||1999 P/E||Est. Growth||P/E in 5 years||P/E in 10 years|
But many of today's investors are unfazed by history -- and by the failure of any large-cap stock ever to justify, by its subsequent record, a P/E ratio anywhere near 100. As the chart nearby shows, of the 33 stocks (18 tech and 15 nontech) that have a capitalization over $85 billion today, an incredible nine currently have P/E ratios in excess of 100, and six of those are in the top 20.
Supporters of these valuations point to their fantastic growth and rosy prospects. And indeed, analysts' estimates of future earnings growth, collected by the Institutional Brokers Estimate System, have predicted that these stocks' earnings per share will grow more than twice as quickly over the next five years as the S&P 500.
But once a firm reaches big-cap status -- ranked in the top 50 by market value -- its ability to generate long-term double-digit earnings growth slows dramatically. Schlumberger, an oilfield-service company, was alone when it attained a 10-year growth rate of 35% in the 1970s, but no investor would have been happy picking this stock at the height of its earnings growth in 1980. Merck has been able to reach 10-year earnings-per-share growth rates near 20% in the 1980s. And yes, Microsoft has achieved a 10-year growth rate in the mid-40s. But Microsoft did not reach big-cap status until 1993.
Even if the fantastic long-term growth rates IBES predicts for the tech companies come true, they won't be nearly good enough to sustain current values. I calculated what the P/E ratio of each stock would be, assuming that these earnings estimates not only are realized in the next five years but are even replicated in the following five. To determine the future price of these stocks, I assume that investors expect to receive an average 15% annual return on these highfliers. Given the volatility of these tech stocks, this assumption is reasonable, and it is doubtless considerably less than many investors expect.
The results are not comforting. Even if the earnings estimates are realized, in five years the average P/E ratio of the "over-100 P/E" stocks drops only to 88.6. And three (America Online-Time Warner, JDS Uniphase and Yahoo!) remain over 100. If the IBES estimates for earnings growth can be maintained for 10 years, the P/E of these stocks fall only to the mid 40s. Even though these stocks will by then totally dominate the market, they will be priced at twice the level projected for the S&P 500.
The 15 nontech stocks with market capitalizations over $85 billion look like a much safer investment. I assumed a return of 10% per year, in line with historical market returns. The current P/E of the big-cap nontech stocks is currently just over 30, a bit higher than the S&P 500 (assuming the same 10% return). And their projected earnings growth rate, at 13.7% per year, is just above that of the S&P 500. In five years the P/E of nontech stocks falls below 24, and in 10 years to just over 20 -- a very reasonable P/E ratio considering the increased productivity growth and stability of our overall economy compared with the historical record.
What does all this mean? Our bifurcated market has been driven to an extreme not justified by any history. The excitement generated by the technology and communications revolution is fully justified, and there is no question that the firms leading the way are superior enterprises. But this doesn't automatically translate into increased shareholder values.
Not From Sales Alone
Value comes from the ability to sell above cost, not from sales. If sales alone created value, General Motors would be the world's most valuable corporation. In a competitive economy, no profitable firm will go unchallenged. Margins must erode as others chase the profits that seem so easy to come by now. There is a limit to the value of any asset, however promising. Despite our buoyant view of the future, this is no time for investors to discard the lessons of the past.