Friday, April 15, 2011

A Look at Big Cap Tech Valuations

Check out the market value and multiples of earnings of the following stocks in 2001 (these are not peak valuations by any means...the bubble had already burst) compared to 2010:

2001        
Stock  |Market Value|   Earnings 
AAPL | $ 5.3 billion  |$-25 million
DELL  | $ 74 billion  |$ 1.2 billion 
MSFT |$ 401 billion |$ 7.3 billion 
CSCO  |$ 138 billion |$-1.0 billion
Total  |$ 618 billion |$ 7.5 billion

2010
Stock | Market Value|  Earnings
AAPL|$ 307 billion | $14.0 billion
DELL |  $ 29 billion   | $ 2.6 billion
MSFT| $ 225 billion |$18.8 billion
CSCO | $  97 billion   | $ 7.8 billion
Total | $ 658 billion  |  $43.2 billion

So the earning power compared to market capitalization for these tech stocks has dropped meaningfully over the past decade or so.

Some things for consideration:

Even though Apple's explosive growth is remarkable, it's worth noting that none of the above businesses have exactly suffered financially in the past decade. Look beyond the headlines (there are obviously some very real threats) and it's clear that each has materially higher earning power now than they did a decade ago.

For Microsoft, Cisco, and Dell the lousy returns has not been driven by poor business performance over that time. It's that their stock prices made no sense back then. So business performance didn't cause lousy shareholder returns...it was the prices paid relative to approximate intrinsic value. Too much being paid for an overly optimistic future. I suspect the same will turn out to be true for many of today's high flyers (and I'm not talking about Apple, it has been an incredible stock but still seems not that expensive adjusted for net cash and expected 2011 earnings).

Again, the 2001 numbers are post-bubble market prices. All of the above firms were well off their bubble highs by 2001 so valuations looked even worse a year earlier (Cisco's market value alone hovered around $ 600 billion during the the bubble).

As a result of inventory write-downs, Cisco's earnings were well below normalized in 2001 and quickly rebounded. The following year the company earned $ 1.9 billion giving it a price to forward earnings multiple of 71x. Not exactly cheap.

Today, most of the above companies have enormous amounts of net cash relative to current market value. Apple and Cisco have north of 20% of market value in cash while Dell's pile of cash is approaching 30% of its market value. Combined the above companies today have more than $ 120 billion of net cash.

The earnings of the above five companies should be well north of $ 60 billion this year. Back out the cash on the balance sheet from the $ 753 billion market value and you get a combined enterprise value = $ 633 billion. So $ 633 billion buys around $ 60 billion of 2011 earning power or a 10.5x multiple.

A little over a decade ago the future of these businesses looked great (other than Apple, ironically) and prices more than reflected that. If you pay up for an extremely rosy future and it doesn't come to be you lose money. Now it seems the prices of some large cap tech stocks are getting closer to more or less reflecting expected difficulties and other unknowns. None of this is easy to judge considering how fast things change in the world of technology. I say that generally not being a fan of tech stocks. In fact, there's just no technology business that I'm comfortable with as a long-term investment.*

Still, eventually the price gets low enough to provide a more than adequate margin of safety.

What happens when you pay a price that reflects a lousy expected future and even a decent one comes to be?

Not much has to go right** when an investor has a long time horizon and the stock of a decent business (i.e. return on capital may not match the best but must be respectable...so no airlines or automakers) approaches single digit price to earnings. If the external threats are financially catastrophic (i.e. most newspapers in recent years) then almost no price to earnings multiple is low enough. If an investor believes this is the future for some of the above stocks then it makes sense to avoid them.

It's always possible one of these businesses experiencing real trouble now will catch a wave down the road. Just better to not pay up front for that possibility. Instead, pay a price where even a mediocre future outcome will produce satisfactory returns. If the business happens to catch an unforeseen wave that'll be a bonus.

Adam

* Long positions in the stocks mentioned above. These are likely will remain mostly not very large positions. May consider making additional purchases if/when there are further price declines and margin of safety is sufficient. (DELL is by far the smallest position and, for several reasons, requires the largest margin of safety in my view.) The reason these are not larger positions? Because, in general, technology businesses reside in fast changing and unpredictable competitive landscapes. It's just that these businesses over the past couple of years sold at price levels in the market that provided a very large margin of safety in my view. So until that margin of safety shrinks I'm willing to have some limited exposure. Unlike shares in some of my favorite businesses (i.e. those in Stocks to Watch bought at the right price) these tech stocks are mostly NOT long-term investments. Occasionally, some have sold at enough of a discount to be worth the trouble but they will always remain very small positions. Most are involved in exciting, dynamic, and highly competitive industries. That's precisely what makes them unattractive long-term investments.
** If a stock gets into single digit price to earnings multiples, even an earnings stream that shrinks by 20% over 10 years then stabilizes will produce a 6-7% annual returns over ten years as long as the CEO isn't throwing the free cash flow into a furnace. That's nothing great as far as returns go but it's meant as a simple way to gauge downside risk. Some assume a shrinking earnings stream always results in shrinking long-term valuation. That's not the case if the stock is bought at the right price and the earnings in fact do stabilize at that lower level. Possibly somewhat counterintuitive but true. It takes very simple spreadsheet analysis to verify the math on this. Now, if an investor believes the earnings stream will persistently decline or their will be a catastrophic permanent drop in earnings that's another story.
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