At $20 per share, the stock price of America Online Inc. looked grossly overpriced when analyst Patrick Dorsey considered it a few years ago. He just couldn’t figure out how the company would grab enough new revenue growth to justify that price.
Then, it dawned on him.
AOL was not a technology company. It was a consumer company, a brand name that would keep reeling in new subscribers to its Internet service, the same way that Tide and Coke have held on to generation after generation of Americans.
“For 25 million Americans,” said Dorsey, who works for Morningstar Inc., the Chicago mutual-fund and stock researcher, “AOL is the Internet.” With that in mind, he assumed stronger subscriber growth and profit margins and increased advertising revenue. Voila! The price seemed reasonable — not cheap, but fair.
The analysis is less relevant now because of AOL’s decision to acquire Time-Warner. But the example still makes the point that analyzing technology stocks requires investors to throw out some of their old methods.
Of course, substituting new-fangled methods for the tried-and-true may be nothing more than rationalizing hyperinflated stocks. Even Dorsey acknowledges that risk.
But he and others say that because companies have been going public at earlier and earlier stages, they require investors to think differently. Analyzing these stocks is more like envisioning a building that hasn’t been erected yet. Investors have to imagine what the final structure might look like, including the components that go into building it, the experience of the managers and the surrounding environment — the overall market and competition.
With these stocks, many of them still unprofitable, traditional measures such as price-to-earnings ratios simply don’t work. Many young companies are moving so quickly that predicting earnings is like trying to ride a bucking bronco. Analysts who embrace New Think acknowledge the risks. After all, “eyeballs,” the number of people who visited a particular Web site, a popular metric in last year’s net-crazed market, predicted success poorly. Some of the other measures, such as the size of the market or the barriers to entry, may prove useless, too.
But with technology changing rapidly and earnings meager or non-existent, the new metrics are all an investor has.
Step one: Throw out everything you know.
“It’s kind of Zen if you think about it,” Dorsey said. “The first step to Internet enlightenment is to admit that you know nothing.”
Investors also need to accept that tech stocks simply will move up and down more wildly than other stocks, said Phillip Coburn, global technology strategist for UBS Warburg. That’s because their earnings vary more.
Last year, 47 percent of technology stocks reported earnings that were more than 20 percent above or below projections. That compares to just 29 percent of non-technology stocks, Coburn said.
“If you and I were trying to figure out the value of an electric utility, we might have a reasonable shot, but when you get to dot-com companies, those numbers are all over the place,” he said.
As a result, assumptions take on huge importance. For example, Rambus Inc. was trading in early August at $97.25. That’s about twice what Morningstar analyst Jeremy Lopez estimates it’s worth based on his assumption that Rambus can capture 75 percent of the market by enforcing patents.
But if he assumes instead that the chipmaker will be able to enforce its patents completely and dominate its entire market, the stock would be worth $145, he said. (It was trading in the range of $80 per share earlier this week.)
Many analysts start their evaluations of tech companies by estimating the size of a company’s potential market. Investors can find such numbers in business publications and in Wall Street research.
Common sense never hurts, either. Webvan Group Inc., which lets consumers shop for groceries over the Internet and then delivers them to their door, sounds like a great idea, Dorsey said. But if you think about the small number of people likely to use such a service, the business plan doesn’t add up, one reason the company’s stock has floundered, he said.
Even more important, said Robert Chalfin, head of the Chalfin Group Inc., a consultant to tech companies in Metuchen, N.J., is whether profits increase with sales.
The answers to these questions make many Internet companies look questionable.
“Amazon’s sales dollar is never going to be worth more than five or 10 cents in profits,” Dorsey said. That means you can’t compare Amazon to other Internet companies using a common way of valuing Internet stocks that don’t have profits. Comparisons of the price-to-sales ratio, which is the price of the stock divided by per-share sales, only works with similar companies.
Many critics, however, say the ratio is meaningless and only highlights the failure of many Internet companies to earn money.
Other net companies are even further from profitability than Amazon, Dorsey said. Buy.com Inc. plans to sell books, electronics and other items to consumers at little or no profit and make the difference up on advertising, he said.
“If the company says, `Hey, we’re focusing on market share right now and not profitability,’ stay away from it,” Dorsey said. Many Net companies have used that mantra to justify continuing losses.
Next, consider the competition. Taking on computer networking Goliath Cisco Systems Inc. is a fight most Davids won’t win. But a company in a new market that is costly to enter can win.
“The key to investing in technology is finding companies with key competitive advantages,” said John Sykora, co-manager of tech-heavy American Century Ultra fund. “The size of the moat around your castle will define your success.”
He pointed to Qualcomm Inc., which makes technology for cell phones, as a likely winner as the Internet goes wireless. He also likes AOL because it can boost ad revenue at little cost.
“They had 100 percent ad growth in the last quarter, despite their size,” Sykora said. “There’s very, very little cost associated with ad revenue, and with 20 million subscribers, they’re four to five times bigger than their next-largest competitor.”
While some fund mangers insist on a tech company’s profitability, others care more about cash. You have to do a little math to figure out how long a company’s cash will last, but investors can find most of the necessary information in financial statements.
“I probably have 20 percent of the fund in companies that are losing money,” said Jim Callinan, manager of several RS funds that have posted outsized returns. But many of those companies have several years’ worth of cash.
Callinan and Garrett Van Wagoner, who manages several funds that bear his name, said the current downturn in tech stocks is merely an overreaction. In fact, both managers said they look through lists of stocks that are down this year to find future winners.
“A lot of the companies that are out of favor have great business models,” Van Wagoner said. “They’re just wearing brown shoes at a black-tie ball.”
