Stock Valuations
Wednesday, April 29, 1998
by Jeff Fischer (

ALEXANDRIA, VA (April 29, 1998) -- One of our stocks is inexplicably ill. Not sure why, not sure how, not sure what, but this company's earnings estimates have nearly quadrupled since the Fool Port bought the stock -- almost quadrupled, from $0.50 per share to $1.91 -- and the stock is still down.

Even in a market of high-flying technology stocks, 3Dfx (Nasdaq: TDFX) couldn't hold its own today, drifting lower by $5/16. The company is executing beautifully, blowing away the competition, earning far more than was expected, and has a bright future (albeit risky) in the potentially large arena of 3D technology for PCs -- and perhaps not just in gaming.

Computer nerds foresee a future where even your shopping experience at comes at you in 3D, with images so life-like that you'll almost be able to pick up and weigh a book in your hands before you purchase it. (By the way, this would potentially crush another bear argument, which has been: "But people don't want to buy something if they can't first hold it in their hands.")

Sure. Whatever. Back to 3Dfx.

Actually... what is there to get back to on 3Dfx? There's no clear explanation for the stock's quick decline from $35 to $25 over the past two weeks. Investors on our message boards are citing any number of factors, from an unknown problem, to (as we have said here a few times) the freeing-up of 3.5 million shares for sale, to institutional selling. Or maybe it's the valuation. The stock is currently priced at 13 times 1998 earnings estimates. That's not unusual for a chip company, no matter how fast the bugger is growing. In fact, here's where an investment can be damned: It is what it is. Nothing more.

Translated: stocks are primarily valued based on their industry. In the end, there's no way around it. Disk drive makers are rarely granted premium valuations. Same deal with semiconductor equipment companies. Ditto with semiconductor chip companies -- even the mother of them all. Intel grew net income 35% in 1997 and yet still traded at an average P/E multiple of 19. There are exceptions in every industry, when leaders are granted higher valuations than most, such as with Dell Computer, but for the most part... a stock is what it is. And 3Dfx is a chip company.

However, I do have unfounded suspicions that something unusual is up (or down) at 3Dfx to explain this strange activity -- though maybe, just maybe, investors looked at the recent upward earnings adjustments and still decided to sell the stock based on valuation, and the selling fire began and was fed into a roar. Again, the stock is now at 13 times the '98 earnings estimate and at 14.2 times the '99 estimate (which is anyone's guess). For its industry, these multiples are right about on target. This stock is not going to trade anywhere near its growth rate. If it did, 3Dfx would get a P/E of well over 200. To be accurate, it would get a P/E of 1,373 -- that's the rate of earnings growth expected this year.

1,373% earnings growth.

13 P/E on forward estimates.

The market isn't fair, some might say, but a better lesson to take away from this, even so very early in the 3Dfx game, is that the industry overwhelms the individual story when it comes to valuing a stock. (Sorry for repeating this, but it's a sizable thought to consider -- and reconsider. We've discussed it before.) No matter why 3Dfx is down right now, eventually stocks trade at multiples based largely on their industry. Eventually. And largely. So to earn any sort of premium price, this company -- cursed by its roots -- likely needs to continue to blow away the earnings estimates.

Can 3Dfx do so? And even if it can, what kind of P/E multiple will it be granted? Intel has branded itself but it is still given a "chip" company multiple to earnings. Dell has earned a premium valuation for a computer box maker. Will it last? Other companies are now adopting Dell's strategies. We'll see. We'll see with 3Dfx of course, too. So far -- despite the earnings surprises -- the stock is apparently staying true to its industry when it comes to the valuation granted.

The Fool Portfolio rose on the back of a new high made by America Online (NYSE: AOL). The online dominator has a market cap of about $17 billion. People have been screaming for years that it's overvalued -- a nice judgment call. But nothing is overvalued or undervalued in the present -- every stock is the value that the market gives it. If you personally call it overpriced or underpriced, that's merely your opinion.

Is the market always right? Of course not.

What the market is trying to do is value companies going forward -- into the future. The market always looks ahead. Therefore, if you don't believe that AOL has a future where the underlying business will be worth at least $17 billion, you're currently at odds with the market. The market thinks that AOL will be worth at least $17 billion, and because it foresees that, it values the company that way even now.

Based on today's new high on large volume, many investors see a future where AOL is valued at more than $17 billion. Consider the current snapshot for AOL: revenue of about $3 billion this year, several existing revenue streams, numerous means to leverage its customers, already profitable, no real competition, pricing power, very young industry, fastest-growing industry in the world, leadership in several international markets -- and, again, a $17 billion market cap.

It was shared in Tuesday's Investor's Business Daily that AOL is comfortable with earnings estimates of $0.12 per share for this quarter, which will be announced on May 6. Adding fuel to yesterday's upgrade from DLJ Securities, today Merrill Lynch resumed positive coverage on the stock and set a $100 price target. As well, the new all-time high certainly attracted "momentum" investors who piled into the stock.

Boil it all down, though, and the $17 billion market cap apparently has room to grow in the minds of investors, and that's why the stock is rising. Down the road, investors are foreseeing more potential value at AOL than $17 billion. The longer out you look, the greater the possibility. In the meantime, though, the stock could go anywhere.

Fool on!

--Jeff Fischer

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Stock Change Bid ---------------- AMZN --- 95.50 AOL +5 1/8 80.50 T - 5/16 59.25 DD + 3/4 72.44 DJT + 3/16 8.38 XON - 7/16 72.94 INVX - 1/16 24.81 IP - 3/16 51.81 IOM - 1/8 8.19 KLAC - 3/16 40.81 LU +1 5/8 74.13 COMS +1 1/16 33.94 TDFX - 1/2 24.75 SPY + 5/8 109.19
Day Month Year History FOOL +1.67% 9.01% 22.37% 310.68% S&P: +0.88% -0.65% 12.80% 138.79% NASDAQ: +1.08% 0.87% 17.91% 157.11% Rec'd # Security In At Now Change 8/5/94 710 AmOnline 3.64 80.50 2113.71% 5/17/95 1960 Iomega Cor 1.28 8.19 539.44% 10/1/96 84 LucentTech 23.81 74.13 211.34% 9/9/97 290 38.22 95.50 149.86% 8/12/96 130 AT&T 39.58 59.25 49.71% 2/20/98 215 DuPont 59.83 72.44 21.06% 1/8/98 115 S&P Depos. 95.91 109.19 13.85% 2/20/98 200 Exxon 64.09 72.94 13.80% 2/20/98 270 Int'l Pape 47.69 51.81 8.64% 4/30/97 -1170*Trump* 8.47 8.38 1.11% 1/8/98 425 3Dfx 25.67 24.75 -3.57% 8/24/95 130 KLA-Tencor 44.71 40.81 -8.72% 6/26/97 325 Innovex 27.71 24.81 -10.46% 8/13/96 250 3Com Corp. 46.86 33.94 -27.58% Rec'd # Security In At Value Change 8/5/94 710 AmOnline 2581.87 57155.00 $54573.13 9/9/97 290 11084.24 27695.00 $16610.76 5/17/95 1960 Iomega Cor 2509.60 16047.50 $13537.90 10/1/96 84 LucentTech 1999.88 6226.50 $4226.62 2/20/98 215 DuPont 12864.25 15574.06 $2709.81 8/12/96 130 AT&T 5145.11 7702.50 $2557.39 2/20/98 200 Exxon 12818.00 14587.50 $1769.50 1/8/98 115 S&P Depos. 11029.25 12556.56 $1527.31 2/20/98 270 Int'l Pape 12876.75 13989.38 $1112.63 4/30/97 -1170*Trump* -9908.50 -9798.75 $109.75 1/8/98 425 3Dfx 10908.63 10518.75 -$389.88 8/24/95 130 KLA-Tencor 5812.49 5305.63 -$506.87 6/26/97 325 Innovex 9005.62 8064.06 -$941.56 8/13/96 250 3Com Corp. 11715.99 8484.38 -$3231.62 CASH $11233.54 TOTAL $205341.60

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