The Valuation Game

If this type of analysis interests you, let's work together to find opportunities. Going forward, I hope to look at two or three stocks each week that readers are interested in and try to determine whether those businesses merit investment or caution or even a short position. Please feel free to submit stocks you are interested in to my email address for consideration.

Today let's look at two companies with different profiles -- Research In Motion (RIMM Quote) and Thermogenesis (KOOL Quote) -- and determine how a value-conscious investor should approach these equities.

RIMM, Market and Valuation Pioneer

Research In Motion is a great company with a great product. I have a basic Blackberry 7200 that I use all day every day. Still, all companies inevitably have a valuation potential, and RIMM sure has much future success baked into the current stock price. There is a little concept called a product life cycle (closely related to the business cycle). This means that growth is accelerated early in the cycle as product adoption is rapid and slows as the product matures; as this happens, the market also becomes saturated, and competition increases.

The same is true of margins. Margins on products are strong early in a cycle as competition lags and early adopters pay up. We needn't look much further than cell phones, personal computers, DVD players and flat-screen televisions to see what happens to end-market prices as a product matures.

Decreases in end-market prices reduce margins because those prices come down faster than the cost of manufacturing the products falls. That is also why buying shares in makers of consumer electronic components has proven to be such a bad long-term investment. As consumer prices decrease, companies have to squeeze component makers to stay profitable, but there is a limit to how much squeezing is possible.

Investors always overpay for rapid revenue and profit growth and generally extrapolate this linearly and infinitely until an event illustrates otherwise. The way to overcome this pitfall is to identify relevant comparison companies at maturity and establish realistic benchmark valuation for a dose of reality. Let's try this out for RIMM and see how the company stacks up.

I have chosen Palm (PALM Quote), Nokia (NOK Quote) and Motorola (MOT Quote) for comparison. All numbers are 2008 or forward.