FOOL ON THE HILL: An Investment Opinion
Do These Values Seem Screwy?

As J.P. Morgan ended a century of independence by announcing its purchase by Chase Manhattan, several pundits looked askance at the premium being paid by the acquiror. But J.P. Morgan, even with this premium, is priced at the same level as Corvis, an optical networking company with zero revenues. If the concept of "overvalue" is on a sliding scale, how do investors measure if a company has slid off the chart? Price-to-sales and price-to-earnings-growth ratios do not come close to providing a complete picture.

By Bill Mann (TMF Otter)
September 14, 2000

As I was watching the news of the Chase Manhattan (NYSE: CMB) takeover of J.P. Morgan (NYSE: JPM), I realized just how anesthetized I had come to the shoveling of a billion here or there onto a company's market capitalization. Certainly corporate dollars come in significantly larger numbers than individual ones, but once upon a time a billion dollars was a huge sum of money. As recently as 1981, for example, big, bad General Electric (NYSE: GE) was valued at $13 billion. GE is hardly a newcomer to the scene -- it is the only original component of the Dow Jones Industrial Average that remains today, more than a century later.

So the commentators were debating whether $30 billion was too rich a price to pay for J.P. Morgan. J.P. Morgan is also a Dow component, a stalwart of American finance. It is safe to say that there are few financiers that had more influence on America's development than the company's founder, J. Pierpont Morgan. And although J.P. Morgan has actively been seeking out a merger partner over the last year or so, it would be a gross overstatement to say that the company has had financial troubles over the last decade.

And yet, J.P. Morgan, at $30 billion, may be overpriced, according to some.

But contrast this with the market cap of some of the Young Turks of the "new economy," and this concept of overvalue may very well come into strange perspective. Let's contrast a few. Before we do, I'm going to give a standard warning: Unless there is specific content to the contrary, these comparisons are only observations. I am not saying that one is overvalued and one is undervalued. In fact, the "overvalued" one in many situations could prove to be the better long-term investment. Believe me, if I actually consider a company to be overvalued, I will not be subtle about saying so.

So, J.P. Morgan, a company with annual revenues approaching $12 billion and a rapidly expanding earnings per share rate (though not a topline growth rate) is overvalued at $30 billion. What then of Corvis (Nasdaq: CORV), an optical networking company with some neato-mosquito technology and losses of $121 million on zero revenues? Well, at current prices, Corvis has a market cap of $29 billion.

We have no earthly idea how to judge Corvis' cash flow management, because they've got no flow whatsoever. No inflow at least, only outflow. Yet somehow it is worth as much as J.P. Morgan.

What are some others? Try these on for size:

General Motors (NYSE: GM) $39 billion
Ariba (Nasdaq: ARBA) $36 billion

GM's sales for the trailing 12 months were $180 billion. Ariba's were $160 million. And yet the market has valued them nearly the same.

Medtronic (NYSE: MDT) $61 billion
Juniper Networks (Nasdaq: JNPR) $62 billion

This one surprised me, but maybe it shouldn't have. Juniper's premiums to sales and cash flows make my hair curl. Granted, its high-end routers address perhaps the fastest-growing and most-dynamic market in existence today, but the company is priced at a cash flow multiple of more than 1400. NOW 50 component Medtronic, the dominant player in device medical therapies such as pacemakers, isn't exactly in a sleepy backwater business either, and is priced at a dowdy 47 times cash flow. But where the average analyst estimate for Medtronic calls for 18% revenue growth per annum, for Juniper it is just south of 50%.

Do you think 50% long-term annual growth justifies a price-to-sales ratio in excess of 200? The fact that the growth rate in consecutive quarters currently approaches 50% gives some credence to the notion that Juniper may actually be priced accurately. But still, that's an awful lot of future growth built into current prices.

It's an incomplete view
I'm not particularly interested in trying to justify Juniper's market capitalization. These comparisons are like the old adage of five blind men each feeling a different part of an elephant. Each is going to describe it correctly, but incompletely. With technologies such as Juniper's or Corvis', I seriously doubt anyone's ability to make a discounted cash flow valuation argument that doesn't require assumptions that may be best described as "magic." At the same time, anyone looking at a Cisco (Nasdaq: CSCO) knows full well that certain companies have exceeded even the most spectacular growth numbers assigned them by investors, and have done so in a consistent enough way that valuations previously unimaginable are now common.

But there's something that should be inherently sobering about sidling up to the bar and saying, "I'll buy me a shot of that Juniper (coincidentally, juniper is the basis of gin), and I don't mind paying for all that growth up front." Because, as anyone holding Iomega (NYSE: IOM) will tell you, sometimes not all of that growth shows up. And, as holders of Lucent (NYSE: LU) know, sometimes even if the market for a company's products continues to grow, the dual tyrannies of short product cycles and enormous research and development requirements can turn today's darling into tomorrow's also-ran in a heartbeat.

This is precisely why highly aggressive investors should never be fooled into believing that they are somehow superior to those choosing to buy less-volatile issues. The person who has held onto CP&L Energy (NYSE: CPL), the parent company of Carolina Power & Light, this year has greatly outperformed those holding such luminaries as Yahoo! (Nasdaq: YHOO), Nokia (NYSE: NOK), and even Cisco. For the big multiples mean that companies can in fact enjoy stellar business growth and yet have their share prices move, at best, with bond-like torpor over significant periods of time.

And be careful bandying about a billion here and a billion there in market cap. Corvis may in fact have a world-beating technology, but wondering right now whether it is a $30 billion company or a $3 billion company really grossly misses the point. There is nothing to go on for Corvis right now but bench test results that show its technology to be earth-shattering in nature. If these products turn out to only be "groundbreaking" or "trendsetting" in the real world, we may soon see why an earnings-less company like Corvis can fall in a way that one with huge revenues, assets, and profits like J.P. Morgan never would.

Again, not a statement of doom for this company or others like it, but a reminder that you should know what you are buying, and know how much of its future growth is already factored in.

As an aside, Fool Community member eWhartHog wrote as clear an explanation of the perils (or rather, considerations) of growth by acquisition as I have seen in a long time. Any investor who owns companies that are acquisitive in nature should take the time to understand how, even using proper accounting, acquisitions can skew the apparent rate of growth for the purchasing company.

Last week I wrote about the single-letter-ticker stocks, noting that there were three letters that were as of yet unclaimed. Well, it's down to two. French entertainment company Vivendi (NYSE: V) claimed one of the remaining single letters, leaving only I and M behind.

Fiat Fool!
Bill Mann, TMFOtter on the Fool Discussion Boards

Related Link:

  • Chase Asks for Morgan's Hand, Breakfast With the Fool, 9/13/00