Tech Stock valuations for the Old and New

Let us start with the bottom line: Valuation is challenging, but rewarding work! Contrary to popular belief, you don't need a postgraduate degree in economics or mathematics to determine the value of a business--whether it's in retailing, electronics, pre-cast concrete, or the Internet.
Written by Curtis J Montgomery, Contributor
Let us start with the bottom line: Valuation is challenging, but rewarding work!

Contrary to popular belief, you don't need a postgraduate degree in economics or mathematics to determine the value of a business--whether it's in retailing, electronics, pre-cast concrete, or the Internet.

Remember, once you know the true value of a business, you can sit back and wait for the (wildly emotional) stock market to offer ridiculously low prices on your favorite stocks. Of course, if you don't understand valuation, how would you recognize a bargain if it bit you in the nose? Without this most basic investing tool, you are left at the mercy of the market.

Generally speaking, the easiest businesses to value are those with a history (at least five years) of consistent or, better yet, consistently growing earnings. Warren Buffett became a gazillionaire looking for such companies using "intrinsic value" calculations…OK, plus a pinch of genius.

Today, many exciting new economy businesses are in the early stages of their growth cycle. They have inconsistent earnings, or are seriously loss making, and they are sometimes valued on the promise of future greatness. Experienced investors know valuation is better performed with data, and not with promises.

With that thought in mind, here are a few of the most common and historically relevant methods of valuing technology companies--valuation based on subscribers, cash flow, revenue, and earnings.

The writer is CEO of Asia-centric personal finance site WallStraits.com.

Subscriber-based valuations…for Internet businesses

How do you value a company with no earnings, and no earnings in sight? That's becoming an increasingly popular question as more tech and Internet business models arrive at the stock exchange seeking public capital in the form of an initial public offering (IPO).

But before you run to the ATM to subscribe for a few lots of the next hot tech IPO, you better have an answer for that "how" question (or at least have thought about it). After all, we strive to be investors--or at the very least, educated speculators--and not just blind gamblers.

One time-tested valuation method you can apply to a "profitless" Internet company is called the "subscriber-based" valuation. This valuation has become a standard of the Internet age, but it dates back further than you might think.

Before the Internet, the subscriber base was a common valuation metric for media and communication companies that generate regular subscription fees from users--like cellular phone companies, cable TV companies, magazine and newspapers and online companies.

Often, in a subscriber based valuation, analysts will calculate the average revenues per subscriber over their lifetime and then figure the value of the entire company based on this calculation.

For example, let us assume that Pacific Internet has six million members and each sticks around for an average of 30 months, and spends an average of S$20 per month. Using that valuation method, the company is worth S$3.6 billion (or 6 million x S$20 x 30).

This sort of valuation is also used for cable TV companies, Internet Service Providers (ISPs) and cellular phone companies. You will often hear that a cellular phone or cable company has been acquired for S$2,000 per subscriber or such.

However, not every Internet company comes to the public capital markets with such a straightforward business model that clearly defines the value of every subscriber. Take a horizontal lifestyle portal like SPHAsiaOne, which hit the Singapore IPO scene during mid-2000 at S$0.60 per share.

AsiaOne attracts some 40 million pageviews per month, making it one of the most visited Web sites in the region. But, what is the value of each viewer?

There is one major revenue source for portals like AsiaOne--banner advertising. The portal charges advertisers a fee of about S$40 per CPM (thousand pageviews). Therefore, each viewer has the direct value of S$40/1000, or S$0.04 each. Now you know what you're worth each time you click onto AsiaOne! Of course, each page may be loaded with several banners, multiplying the value of each viewer.

In addition, portals like AsiaOne, Yahoo or Lycos will be continually finding novel ways to profit from each viewer. Some portals rent virtual space to merchants who want to bring their goods and services to viewers. In this case, the portal earns rental income as well as transactional fees on all goods sold. Other portals may offer fee-based services ranging from bill payments to stock price alerts.

Of course, as Web-based businesses get more creative on value extraction, the assessment of value per viewer becomes more challenging for the investor.

It is therefore wise to keep a close eye on emerging industry acquisitions--how did the acquiring company calculate the acquisition price? Those able to answer the question and apply it to similar companies in the same or similar industries will have an edge over other investors looking for true value.

This valuation approach certainly goes a long way towards explaining why subscription-income based companies spend heavily to attract and maintain their members. Every cable TV and cellular phone subscriber is directly related to the valuation of the business.

Sometimes it is the companies in one subscriber-based business that recognize the hidden value of similar businesses and acquires them. Examples include Microsoft's acquisition of several cable TV companies around the world; Pacific Century's acquisition of cable TV, media and phone companies in Asia; SPH's diversification from newspaper and magazines into cable TV (SCV), a mobile phone service (MobileOne) and Internet portals (AsiaOne).

Cash flow-based valuations…EBITDA & non-cash charges

Few investors consider cash flow when evaluating companies. Yet it is probably the most common measure of valuing public and private companies that is used by investment bankers.

Cash flow is literally the cash that flows through a company during the course of its fiscal year, after deducting all fixed expenses. It is normally defined as earnings before interest, taxes, depreciation and amortization (EBITDA).

Why do we look at earnings before interest, taxes, depreciation and amortization? Interest income, expenses and taxes are all tossed aside because cash flow is designed to focus on the operating business and not on secondary costs or profits. Taxes in particular depend on the vagaries of the laws in a given year, and can cause dramatic fluctuations in earning power. Say Madam Wong's Umbrellas (MWU.SG) faced a tax rate of 15 percent in 1999, but the rate more than doubled in 2000. This situation would overstate the company's current earnings and understate its forward earnings, thus masking its real operating position.

A canny analyst would use the growth rate of earnings before interest and taxes (EBIT) instead of net income to evaluate the company's growth. EBIT is also adjusted for any one-time charges or benefits.

As for depreciation & amortization, these are called non-cash charges--the company is not actually spending any money on them. Rather, depreciation is an accounting convention (for tax purposes) that allows companies a break on capital expenditures, such as when plant and equipment age and become less useful.

Amortization normally comes in when a company acquires another company at a premium (to its shareholder's equity). This premium or discount is accounted for on the balance sheet as goodwill, which needs to be amortized over a set period of time according to generally accepted accounting principles (GAAP).

When looking at a company's operating cash flow, it makes sense to toss aside such accounting conventions that might mask cash strength.

When & how to use Cash Flow
Cash flow is most commonly used to value industries that involve tremendous up-front capital expenditures and companies that have large amortization burdens. Cable TV companies like Singapore Cable Vision (SCV) and semiconductor manufacturers like Chartered Semiconductor (CSM.SG) might show negative earnings for years--incurring a huge capital expense to build their cable networks or wafer fabrication plants--even though their cash flow may actually grow.

This is because huge depreciation and amortization charges can mask the companies' ability to generate cash. Sophisticated buyers of these properties use cash flow as one way of pricing an acquisition; it also makes sense for investors to use it.

There are also some very complicated calculations such as discounted cash flow, Economic Value Added (EVA) and others, but they are beyond the scope of this article. The key is to find ways to separate businesses that truly generate cash from those that eat it up. The most straightforward way for an individual investor is to use cash flow is to understand how cash flow multiples work. In a private or public market acquisition, the price-to-cash flow multiple is normally in the 6 to 7 range. When this multiple reaches 8 or 9, the acquisition is normally considered to be expensive. Some advise selling a company when you are offered 10 times cash flow. Leveraged buyout experts look for opportunities to buy companies for less than 5 times cash flow. For investors interested in these more sophisticated value metrics, we recommend a trip to the local business section of the bookstore or the finance section of the library. Have fun!

Revenue-based valuations…the Price/Sales Ratio

A company generates revenues each time a sale is made. Revenues are sales of a company's products or services to their customers.
Even a company with no profits or earnings can have revenues. A start-up company, for example, can experience heavy losses as they build the necessary business infrastructure and spend heavily on marketing and advertising prior to seeing sales growth kick in. Wise investors will recognize the potential in such businesses and value them based on their ability to successfully build revenues even before they start making significant profits. Revenue-based valuations are achieved using the price/sales ratio, or PSR.

The PSR takes the current market capitalization of a company and divides it by the last 12 months of trailing revenues. The market capitalization, or "cap" is an indication of the total market value of a company--it is calculated by simply multiplying the total number of outstanding shares of a company by the share price. For example, if MWU.SG has 10 million shares outstanding with a share price of S$10, its market capitalization is S$100 million.

Some investors are even more conservative and add the current long-term debt of the company to the total current market value of its stock to get the market capitalization. The logic here is that if you were to acquire the company, you would acquire its debt as well, effectively paying that much more. This avoids comparing PSRs between two companies with differing levels of debt.

The next step in calculating the PSR is to add up the revenues from the last four quarters and use this number to divide the market capitalization. Say MWU.SG has S$200 million in sales over the last year and currently has no long-term debt. The PSR would be 0.5. The PSR is a measurement that companies often consider when making an acquisition. If you have ever heard of a deal being done based on a certain "multiple of sales", you have seen the PSR in use.

As this is a perfectly legitimate way for a company to value an acquisition, many simply borrow it for use in the stock market to value a company as an ongoing concern.

Interpretation of PSR
The lower the PSR…the better. Ken Fisher, who is most famous for using the PSR to value stocks, looks for companies with PSRs below 1 as an indicator of value. PSR is an especially valuable valuation tool when a company has not made any earnings in the last year. Unless they are headed for bankruptcy, the PSR can tell you whether or not the concern's sales are being valued at a discount compared with its peers. If MWU.SG lost money last year, but has a PSR of 0.50 when many companies in the same industry have PSRs of 2 or higher, you can assume that if Madam Wong whips the company back into shape and starts making money again, then it will have a substantial upside as the shares increase (for the PSR to be more in line with its peers).

There are some recession years (1997-1999 for most of Asia) when none of the companies in cyclical industries like construction and heavy equipment make money. Does this mean that all construction companies in Asia are worthless? No. So how can we compare the companies? Well, equip your toolbox with the PSR and measure how much you are paying for a dollar of sales instead of for a dollar of earnings.

Earnings-based valuations…Earnings Per Share and the P/E ratio

The most common way to value a company with earnings (or net income or net profit) is by…you guessed it, looking at its earnings--that is, the money left over after a company pays all its bills.

To allow for fair comparison, most people who look at earnings calculate the Earnings Per Share (EPS) by simply dividing the dollar amount of the earnings a company reports by the number of shares it currently has outstanding.

Thus, if MWU.SG has one million shares outstanding, and due to a particularly rainy year in Singapore earned S$1 million for the year, it will have a trailing EPS of S$1 (S$1 million/1 million shares). This is called a trailing EPS is because it looks at the last full year's reported earnings from the balance sheet--the year that trails behind the current operating year. By itself, however, EPS means absolutely nothing. To look at a company's earnings relative to its price, most investors calculate the price/earnings (P/E) ratio as well. The P/E ratio takes the stock price and divides it by the previous year's earnings. For example, in our example above, if MWU.SG were trading at S$7 per share, it would have a P/E of 7 (S$7/S$1 trailing EPS).

Is the P/E the key value indicator?
There is a large population of individual investors who stop their entire analysis here; the trailing P/E ratio or "multiple" is usually reported in the daily newspapers. But with no regard to other forms of valuation, this group of investors would charge blindly ahead, ignoring the vagaries of equity analysis.

Popularized by Benjamin Graham--who, incidentally, used a number of techniques other than low P/E to screen for value stocks--the P/E method has been oversimplified by those who look only for "low P/E" stocks--that is, companies that have a very low price relative to their trailing earnings.

The P/E is most often used in comparison with the current rate of growth in EPS. A wise investor would assume that the EPS growth rate for a company should be roughly equal to its P/E ratio.

For example, if MWU.SG showed an EPS growth of 15 percent in 2000 versus 1999, and the company's P/E were 15, this would suggest a "fair" valuation. Since the company's P/E was only 7 in the example above, the investor should look out for a potential "undervalued" situation as a further explanation of the low price.

In the end, the P/E has to be viewed in the context of growth, with a significant margin for error. If MWU.SG were to show a decrease in earnings (or a loss) in 2001, the P/E becomes less useful than the other valuation methods.

Are low P/E stocks always a bargain?
With the availability of computerized screening of stock databases, stocks that have low P/E due to mispricing have become increasingly rare. When Benjamin Graham formulated many of his principles for investing, investors had to painstakingly search through pages of stock tables by candlelight to find companies with extremely low P/Es. Today, all you have to do is punch a few buttons into an online database to get an instant list of candidates.

These technology advances add efficiency to the stock markets. When you see a low P/E today, more often than not it deserves to have a low P/E. Many savvy investors have more than likely seen the low P/E, but decided to continue to discount the stock's price due to, say, poor growth prospects in the future versus the stock's past achievements. This is not to say you cannot find some great low P/E stocks; they may have simply been overlooked. In general, though we need other valuation methods to confirm the value indicated by a simple P/E ratio.

P/E in relation to Growth
The most common extension of the P/E valuation method is to compare it to the company's earnings (EPS) growth rate, or PEG. The PEG takes the annualized rate of growth out to the furthest estimate and compares this with the current stock price. Since it is future growth that makes a company valuable to both an acquirer and a shareholder, this makes intuitive sense. Looking solely at the trailing P/E is like trying to see the future when you're solidly stuck in the past. If MWU.SG is expected to grow its earnings over the next two years at 7 percent a year, it will have a PEG of 1 (PE of 7/7% EPS growth).

A PEG of 1 suggests that a company is fairly valued. If MWU.SG only had a P/E of 5, but was expected to grow at 10 percent a year, it would have a PEG of 0.5--implying that it is selling for half of its fair value. If the company has a P/E of 20 and is expected to grow at 10 percent a year, it would have a PEG of 2; double its worth, according to the assumption that P/E should equal the EPS rate of growth.

While the PEG is most often used for growth companies, "Year-Ahead PEG" (YEAH PEG) is best suited for valuing larger, more established businesses. The YEAH PEG uses the same assumptions as the PEG but looks at different numbers. As most earnings estimates services provide estimated five-year growth rates, these are simply taken as an indication of the fair multiple for a company's stock going forward. Thus, if a company's current P/E is 10 but analysts expect the company to grow at 20 percent over the next five years, the YEAH PEG is equal to 0.5, and the stock would look cheap using this method. As always, investors must be cautious to view the PEG and YEAH PEG in the context of other measures of value and not consider them as instant path to profits.

Interpretation of Multiples
The PEG and YEAG PEG are useful indicators of value. Both use the assumption that P/E should be equal to the earnings growth rate. Unfortunately, in the real world, this is not always the case. Thus, investors are often left to look at estimated earnings and estimate what fair multiple someone might pay for the stock. For example, MWU.SG has historically traded at 10 times earnings and is currently down to 7 times earnings because it missed estimates during the last six-months; it might be reasonable to buy the stock if you expect the company to meet expectations for the next six months and return to the historical 10 times multiple. When investors project fair multiples for a company based on future earnings estimates, they start to make a heck of a lot of assumptions about what will happen in the future. Predicting the future dangerous stuff. There will always be risk involved. Should your assumptions turn out to be wrong, the stock will probably not go where you expected it to go.

Basically, you do your best to uncover the information necessary to make accurate estimates. At the same time, many other investors and analysts are out there making their own investigations into the company, and forming their own assumptions and estimations--hence, the same stock can look cheap to the buyers and expensive to the sellers.

A modification of the multiple approaches is to determine the relationship between the company's P/E and the average P/E of the local index for the market in your country, such as the Straits Times Index in Singapore.

So, if MWU.SG has historically traded at 150 percent of the Straits Times Index average P/E, due to Madam Wong's savvy management skills and lots of rain, and the Straits Times Index average P/E is currently 10, many investors believe that MWU.SG should eventually hit a P/E of 15 to be at fair value. This historical relationship will require some pretty sophisticated databases and spreadsheets to calculate and is not widely used by individual investors, although many professional money managers often use this approach.

One last method of comparison is to compare the company's P/E to other companies within their same industry. The assumption here is that companies competing against each other in the same industry will have a similar P/E ratio unless one has a certain competitive advantage over another.

Another common use of the PSR, that we mentioned above, is to compare companies in the same line of business, using the PSR in conjunction with the P/E in order to confirm value. If a company has a low P/E but a high PSR, it can warn an investor of potential one-time gains from last year that are pumping up EPS. Finally, new companies in hot industries are often priced based on multiples of revenues and not multiples of earnings. Internet and Biotech companies, for example, are commonly viewed from the PSR perspective for value.

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