Detox: A Dose of Investing Reality

Detox is for people who want to sober up. Detox, a new column starting today, is for people who've had enough of the stock market's stupefying irrationality.

Detox

Watching the Top Line at Overvalued Oracle

While the Dow and the Nasdaq now reside well below their all-time highs, the mania surrounding hundreds of stocks has abated only slightly. There's still plenty of overindulgence left to address.

Like all the good drying-out clinics, Detox has its own special treatment. Insobriety causes people to live in parallel worlds, divorced from reality. And Detox is an attempt to reintroduce a measure of realism back into the investment equation. The biggest -- and still widely believed -- lie of this 10-year bull market has been that fundamentals don't matter, and that valuation methods should change. That's the sort of nonsense that will send you to the poor house.

Plumbing

Far From the Tree? Apple falls

Looking at a company's fundamentals, its inner workings, has become all the more critical as markets have climbed. Soaraway stocks -- think Apple (AAPL:Nasdaq - news - boards) -- routinely halve in value when bad news comes out. High-performance machines like aircraft engines require regular detailed inspections. Ditto high-performance stocks. Detox will deconstruct companies' financials and ask what they're really saying, and then compare that to the tale the stock price is telling. The gap between the two is often wide -- and unsustainable.

By contrast, plumbing the fundamentals can turn up companies that have been unjustly rejected by the market. Addiction to pessimism is just as bad for investors' pockets as blind optimism. In that case, Detox will be unbashedly bullish.

But in this climate, bearishness is likely to be a more common stance in this space. Just a cursory glance beneath the hoods of many companies reveals why. A useful tool in the valuation process is the much derided price-to-earnings ratio, which divides underlying per-share earnings of a company into its stock price. In essence, the P/E ratio gives an idea of how fast investors expect a company to grow. A firm with a P/E of 50 is expected to have faster earnings growth than one with a P/E of 20.

Oxidizing Falling down the Copper Mountain

Today, only a tiny fraction of the companies with high P/E's will grow at the supersonic rates they imply. When it becomes apparent that the companies can't keep up a good pace, a flameout always occurs. Check out the chart for Copper Mountain (CMTN:Nasdaq - news - boards), for instance. And very few firms "grow into their multiple," as the touts love to say.

'Rithmetic

The numbers can be telling. Even at its much-reduced stock price of around $55, Yahoo! (YHOO:Nasdaq - news - boards) trades at 115 times forecast 2000 per-share earnings of 48 cents. Anyone buying at this level is essentially paying $115 for every dollar of earnings. How long will it take for Yahoo! to earn a cumulative $55 in earnings (the price paid for the stock)? About 16 years, assuming Yahoo! issues no extra stock and continues to grow earnings at its current 23%.

A bull would interject at this point that Yahoo! will be making nearly $11 per share in its 16th year, and could be trading at, say, 30 times those earnings, giving it a share price of $330, six times above the current one. So why not buy at $55? First off, if Yahoo!'s stock climbed to $330 over 16 years, investors would need to adjust down to take into account what they could make from Treasury bills over the same period. (Investment theory dictates that any return has to be compared with the risk-free yield one could get from a government bond.) Adjusted in this manner, the $330 stock price is really worth $140 today. That's only two and a half times over current levels.

Then one has to assume that Yahoo! won't issue any extra stock and dilute per-share earnings. Most precariously, investors also have to believe that Yahoo! can grow earnings at 20% annually for 16 years. While this may be possible, it's a feat that only companies the caliber of GE (GE:NYSE - news - boards) have come close to achieving. Of course, the bulls will say that the firm will probably accelerate earnings growth. But if there's any time when profits growth speeds up, it's in the early stage -- not five to 10 years down the road. Perhaps most important over the long term, Yahoo!'s success in building a reasonable Web site has been achieved because it has a highflying stock. Will it be able to retain good staff with options priced off a stock in a slow-motion swan dive?

While You Were Seeping

Leaves Are Falling ...and so is Conseco stock

Of course, firms get bought out when they start to slow down (or go out and buy something themselves). But investing on the basis of future mergers and acquisitions is a total crapshoot. And fundamentals matter even here: A bad company will be sold for a low takeout price and some really dire firms may never get bought.

Clearly, investors have set impossible goals for a firm like Yahoo!, and the realization of this has been seeping through for weeks, judging by its tumbling stock. But don't go away thinking this column examines only tech stocks with stratospheric P/E's. No, the same blind optimism can grow around other sectors, and persist even as stocks head for zero. Conseco (CNC:NYSE - news - boards), the once-hot insurance and lending firm down 90% from its all-time high, is currently trading at six times forecast 2001 earnings, and it's still way overpriced. And from time to time, Detox will look at markets-related subjects other than stocks, where conventional wisdom appears to have run amok.

Cheers!

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Know any companies that the market may be misvaluing? Detox would like to hear about them. Please send all feedback to [e-mail].