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3157436 Stock Valuation and Investment Decisions Chapter 8 Cfa

3157436 Stock Valuation and Investment Decisions Chapter 8 Cfa

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market leaders with solid track records. There are probably no more than a
hundred or so firms that would fall into this category. Most of them have
normal financial and market ratios and are valued pretty much like any other
growth stock, as described earlier in this chapter.
Nextarethemid-tierstocks;thereareliterallyhundredsofthesefirms,such
asNVIDIA,Transwitch,andBlackBoxCorporation.Thoughmanyofthem
maynotbehouseholdnames,theyhavebeenaroundforsometimeandhave
demonstratedanabilityto notonlygeneratesubstantialrevenuesbutalsoto
earnsolidprofitsyearafteryear.NVIDIA,forexample,hadsalesofnearly
$650millionin1999andprofitsofover$80million.Manyofthesetechstocks
haveveryhighP/Eratiosandthereforemaynotbecompatiblewithstandard
stockvaluationmodels.Apotentialprobleminvaluingsomeofthesemid-tier
firmsisthattheymaynothavehighlydiversifiedproductofferingsandcus-
tomerbases.Thus,ashiftinindustryfundamentalsortechnologycouldchange
theirfortunes(i.e.,earningsandgrowthrates)dramatically.
Lower-tiertechstocksincludefirmslikebingo.comandLaser
Corporation.Firmsatthisleveltypicallyhaveyettogenerateanyearnings.In
manycases,theyhaveverylittleinrevenues.Valuationofthesefirmsis
extremelydifficultandoftenamountstolittlemorethanhunches.Indeed,these
stocksareoftenboughtbyinvestorswhopaylittleattentiontofundamentals
butinsteadrelyonlittlemorethan“stories,”suchassomemediareportthat’s
relatedtothefirm’sproducts,anunsubstantiatedcommentontheInternet,or
theadviceofafriendwhohassuddenlybecomean“expert”atinvesting.

Tech-Stock Valuation MethodsGenerally speaking, the methods used to
value tech stocks are pretty much the same as those used to value any other
type of stock. However, tech-stock valuation definitely presents some unique

TABLE 8.5

Some Tech-Stock Groups

Numbers

Group Name

of Firms

Selected Firms

Business information services

22

Gartner Group, Keynote Systems

Computer networks

87

Cisco Systems, Juniper Networks

Computer software

227

Microsoft, Oracle

Defense electronics

27

REMEC, Teledyne

Electrical components-

114

Intel, Xilinx

semiconductors
Electronic commerce

59

Amazon.com, eBay

Fiber optics

18

Corning, JDS Uniphase

Industrial automation/robotics

5

Gerber Scientific, Rockwell

Instrumentation—control

10

Datum, Eaton

Internet content

62

CNET, Travelocity.com

Internet services

102

America Online, CMGI

Internet software

94

Ariba, Synquest

Medical—biomedical/gene

145

Amgen, Biogen

Optical character recognition

6

PSC, Scansource

Telecommunications—wireless

57

AT&T Wireless, Vodafone

Telecommunications equipment

139

Lucent, Motorola

Telecommunications services

21

Global Crossing, RCN

Source:Yahoo! finance Web site (finance.yahoo.com).

--Gitman2002.CH08.314-368.CTP 7/19/01 12:20 PM Page 337

challenges.We’ll look at the two primary techniques used to value tech stocks:
discounted cash flow analysis and the use of price multiples. After describing
each of these methods, we will discuss a concept known as the “burn rate,”
and then conclude with an example of a tech-stock valuation.

Discounted Cash Flow (DCF) AnalysisEarlier in this chapter, we noted
that the intrinsic value of any investment is the present value of its expected
cash benefits. Actually, that’s the principle behind the dividend valuation
model (DVM). Recall that in the DVM the value of a share of stock is the
present value of its future stream of dividends. The same can be said of the
dividends-and-earnings (D&E) approach, except that it relies not only on div-
idends but also on expected future earnings, P/E multiples, and the future price
of the stock. Both the DVM and D&E approaches are examples of discounted
cash flow (DCF) models. DCF analysis involves the projection of future cash
flows, such as dividends, which are then discounted back to the present at a
rate that reflects the investor’s required return.
There’s an obvious problem in trying to apply the DVM to the valuation
of tech stocks: Very few of them pay dividends. We could, of course, assume
that the companies will eventuallypay dividends and then discount these div-
idends back to the present to obtain an estimated value. But far more often
than not, such computed values are highly unreliable!A viable alternative to
the DVM would be to use a variation of the dividends-and-earnings approach.
In this version, all of the dividends would be set to zero, so the computed value
of the stock would come solely from our future projection of the firm’s earn-
ings and P/E ratio—in other words, the future price of the stock. That may
work in some cases. But for many tech firms, earnings growth rates are so
uncertain that techniques such as the D&E approach are not feasible. In an
attempt to get around some of the problems that arise forecasting earnings,
some investors use other measures of cash flow, such as free cash flow.But
even here, it is difficult to forecast cash flow figures for rapidly growing high-
tech firms. In fact, it may be more difficultto forecast cash flows for these
firms because of all the assumptions that have to be made regarding growth
rates, capital expenditures, and working-capital requirements. Thus, although
DCF may be useful in valuing some of the larger, more established high-tech
companies, most market observers regard it as impractical in the valuation of
smaller and newer firms.

Price-MultipleMethodsInsteadofusingDCF,alotoftech-stockinvestors
basetheirvaluationsonstockpricemultiples.Todoso,investorsidentify
firmsthatarecomparabletotheonebeingvalued,determinetheaverage(or
typical)multiplesbeingappliedtothosecomparablefirms,andthenuse
it/themtoputavalueonthefirmunderconsideration.Commonlyusedmul-
tiplesincludethosebasedonearnings(price/earnings),bookvalue(price/book
value),andsales(price/sales).Theuseofthesemultiplesfollowsthesame
stepsthatweoutlinedearlierinourdiscussionoftheprice/earnings(P/E)
approach.Thatis,giventheappropriateP/Emultiple,wesimplymultiplyEPS
bytheP/Eratio,andwehaveourestimateofthestockprice.Similarly,we
couldmultiplybookvaluepersharebytheappropriateprice/bookratio,or
salespersharebytheappropriateprice/sales ratio,toestimatethevalueofthe
stock.

338

PART THREEIINVESTING IN COMMON STOCK

--Gitman2002.CH08.314-368.CTP 7/19/01 12:20 PM Page 338

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