FOOL ON THE HILL: An Investment Opinion
With so many stocks currently viewed as being highly valued, how is an investor to tell the difference between one highly valued stock and another? One way is to recognize that valuation can be defined in many ways and opt for a new yardstick. Instead of employing relative P/E or market caps, investors can use the enterprise value to invested capital ratio to discover which stock is in reality the most highly valued.
Before blurting out an answer, keep in mind what the question is asking. No, I'm not looking for opinions on what is currently the most overvalued stock in the U.S. stock market, so all of you Qualcomm (Nasdaq: QCOM) and Rambus (Nasdaq: RMBS) bears can put your hands down. And I'm not necessarily thinking of General Electric (NYSE: GE) either, even though that company currently sports the largest market capitalization in the U.S. stock market at around $560 billion.
Since a certain degree of subjectivity creeps into the conversation anytime valuation comes into play in investing, there are many possible answers to this question. The most highly valued stock based on price-to-earnings ratios may not be the most highly valued stock based on price-to-sales ratios, and vice versa. In fact, every price-to-anything ratio out there is bound to suggest a different stock fitting the "most highly valued stock" description. Since investors have differing, subjective views regarding valuation, it follows that there will be differing answers to this question.
With that in mind, it was somewhat noteworthy to see Robertson Stephens analyst Paul Johnson toss out a suggestion for what he believes is the most highly valued stock in a recent MindShare interview posted on internetstocks.com, a website affiliated with his West Coast-based investment banking firm. Johnson undoubtedly knows a thing or two about highly valued companies, as he has been covering the likes of Cisco Systems (Nasdaq: CSCO) and other infrastructure networking stocks for many years. He was also one of the co-writers of the The Gorilla Game, a popular 1998 high-tech investing handbook. Further, Johnson has written some interesting articles on stock valuation that are well worth reading at the CAP@Columbia website.
Johnson's pick for most highly valued stock in what he terms the "Next Generation Networking" area of the stock market is Juniper Networks (Nasdaq: JNPR), a maker of high-speed Internet routers. Using one valuation yardstick that may be of use to investors trying to spot valuation differences among many of today's high-flying companies, he may have a good case.
Rather than relying on the well-known P/E, Johnson has in the past supported the idea of comparing a company's enterprise value (EV) to its invested capital (IC) to get a better handle on how a company is being valued by the market in relation to a peer group. Just as with the P/E, the EV/IC ratio yields a multiple that an investor can then compare to similarly derived multiples of other companies. But instead of being a multiple of earnings, the EV/IC ratio represents the multiple that investors are placing on each dollar of capital invested in the business. This helps offset a major failing point of the P/E, as that ratio focuses on a company's reported GAAP (generally accepted accounting principles) earnings without taking into account just how much capital is required to generate those earnings.
The EV/IC ratio would be of no more use to investors looking at today's high-flying companies than the P/E if it wasn't for the fact that capital comes at a cost. While it doesn't show up anywhere on a firm's financial statements like cost of debt capital, the cost of equity capital is nonetheless real. And for upstart, high-growth firms such as Juniper that rely heavily on equity capital for their financing, the cost of capital is typically quite high.
For investors plunking down their money in tomorrow's Next Generation Networking firms, the roughly 11% annual historical return of the S&P 500 isn't going to cut it. It's no surprise that investors are currently expecting a much higher-than-average return from a young company such as Juniper, which carries a much higher-than-average degree of risk of becoming an out-and-out failure. But as business thinker Peter Drucker sized up the situation in a recent Business 2.0 interview, "If your cost of capital is based on tremendous stock market gains, then your cost of capital is actually very high if those expectations go down." The EV/IC ratio is one way for an investor to size up just how vulnerable a company such as Juniper is to any downward change in those return expectations relative to other firms.
So, how does Juniper stack up to others in the EV/IC department? Here's a comparison with some of the other Next Generation Networking high-flyers covered by Johnson, including optical networking firm Sycamore Networks (Nasdaq: SCMR), voice-over-IP networking firm Clarent (Nasdaq: CLRN), and, of course, Juniper rival Cisco Systems.
(numbers in millions)
In all cases, I've defined EV as market capitalization (diluted shares outstanding multiplied by share price, in this case closing prices on 6/30/00) plus long-term debt minus cash and short-term investments.
Meanwhile, invested capital was calculated using the Fool's standard formula of total assets minus non-interest bearing current liabilities minus excess cash. In turn, excess cash was considered all cash and short-term investments, as all of these firms turn cash over fast enough that they really don't need to keep much on hand to cover day-to-day cash outlays.
For Cisco, I used Johnson's invested capital figure from a recent report available on Multex. I have a hunch that it may understate Cisco's invested capital a bit, but we'll go with his figure anyway as Cisco's various pooling of interest acquisitions over the years would require us to make many adjustments to its invested capital base. Moreover, using a higher figure won't affect the end result.
Based on the above EV/IC calculations, Johnson indeed seems to be correct in stating that Juniper Networks carries the highest valuation of the Next Generation Networking stocks, topping the value placed on nosebleed valuation poster boy Cisco. Even though Cisco's enterprise value is nearly 9.5 times greater than that of Juniper, each dollar of capital invested in the smaller router company is being valued by the market at nearly twice the multiple.
Just as with the P/E or any other single-shot valuation yardstick, however, the EV/IC ratio doesn't tell the whole valuation story. In fact, it's hard to conclude whether any of the firms are overvalued, undervalued, or fairly valued based using this single measure alone. However, using EV/IC makes sense as a way to get a better idea of how highly one high-flying firm's prospects are being valued by the market compared to others. For an investor looking for an alternative to the P/E, the EV/IC can be a handy addition to the valuation toolbox.
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