Big Tech Stocks Still Teetering on the P/E Precipice

You call this Nasdaq rout a bear market?

Sure, stocks in this tech-heavy index have tumbled by 60% from their highs. But in bear markets past, valuations also have dropped -- to levels where they draw in long-term buyers. Only then can a lasting recovery kick in. And here's the bad news for tech bulls: The steep drop in tech valuations has yet to happen. In fact, the Nasdaq 100 needs to be halved in value before anything approaching real value returns.

To be sure, there'll be (legless) rallies in the Nasdaq from here, and some tech stocks will go up and stay up. But most won't, weighed down by valuations that usually exist only in the most maniacal of speculative bubbles. To some, this is obvious, but to many more, it's not. In short, plenty of investors are betting that the Roaring '90s will soon return. Looking at multiples, they never went away.

Rich Numbers

This column calculates that the Nasdaq 100 index currently trades at 95 times weighted forecast earnings for 2001. For 2002, supposedly a recovery year in many people's eyes, this price-to-earnings ratio is 74. True, this is lower than the forward P/E ratios in excess of 120 that the Nasdaq 100 sported at its peak. But it implies that tech companies, in aggregate, will post annual earnings growth of more than 50% in coming years -- a preposterous notion, considering that they weren't doing that even when the boom was in full swing.

Here's how the numbers work. On July 24, the companies in the Nasdaq 100 index had a combined market capitalization of $1.75 trillion and aggregate forecast 2001 and 2002 earnings of $24 billion and $31 billion, respectively.

Company weights in the Nasdaq 100, however, are adjusted by the index constructors so that they're different from their actual share of the index's total market cap. Some stocks, like Microsoft (MSFT Quote), have a lower weight in the index than their share of the total market worth. Mister Softee's index weight is 11%, though it accounts for 20% of the Nasdaq 100 combined market cap. Others have a higher index weight, like eBay (EBAY Quote), whose index weight is 1.15%, compared with a 0.95% share of total market worth.

To take the weighting differences into account, Detox will use a method cribbed off Tom Coleman of London-based AEquilibrium Investments. This approach produced a Nasdaq 100 market cap on July 24 of $1.739 trillion, with aggregate expected earnings of $18.4 billion for 2001 and $23.6 billion for 2002. Dividing the market cap by the earnings gives a P/E of 95 for 2001 and 74 for 2002. (Through aggregation, losses can be included in total earnings calculations.)

One-Way Street

So what do these P/Es tell us? The Nasdaq will, over time, fall a lot further. If the Nasdaq 100 were to trade at 30 times 2002 adjusted earnings, it would have to decline 60% from July 24 levels, or nearly 1000 points, to 661. This isn't too low a projection: Remember that 30 times is a high P/E for a bear market. And 30 is still arguably too much for a market that's going to struggle to show sustainable earnings growth of more than 20% for the next few years.

As AEquilibrium's Coleman puts it: "To get to reasonable levels, it's really scary how far the Nasdaq 100 has to fall."

The table below shows how far the Nasdaq 100 would have to dip to trade at different multiples.

The Downside
Where the Nasdaq 100 would be if it traded at:	Index value	Percent decline from current level of 1680
30 times 2002 earnings*	672	60%
40 times 2002 earnings	907	46
50 times 2002 earnings	1142	32
*Weighted forecast earnings, see article for explanation. Source: Detox, Baseline.

Why hasn't the Nasdaq 100 plunged straight to the 700-800 level? For the same reason that it went up above 4700: People still believe that a technological revolution is taking place and that many will get rich off it.

Of course, even tech-lovers now laugh at the likes of Webvan. But what about everyone's favorite, eBay? A closer look at the online auctioneer shows how silly things still are.

The Silly Season

eBay trades at 140 times forecast 2001 earnings. Let's crunch some more numbers to see why that's unsustainable. The company says it expects to make revenue of $3 billion in 2005. Analysts reckon eBay can make $1.01 billion in revenue in 2002, a 41% increase on the expected number of $718 million for 2001. For revenue to reach $3 billion in 2005, it has to grow at an average rate of 44% in 2003 through 2005. Note the flawed assumption here. Revenue has to grow faster in the 2003-05 period than it does over the next 12 months or so. People are repeating one of the biggest analytical mistakes of the tech bubble: They believe that torrid growth rates can go on for many years -- and even accelerate from early stage rates.

eBay aims to have a 35% operating margin in 2005. That'd give pretax profits of $1.1 billion in that year. Using the company's current tax rate of 42%, net income would be $610 million in 2005. If that's discounted back using a 10% discount rate, eBay's 2005 earnings are worth $378 million today, or $1.36 a share. In other words, eBay's trading at 47 times discounted 2005 earnings. No bargain.

This exercise shows that even the sainted eBay eventually will fall. Fundamentals always prevail. Unlike in life, the underlying truth -- in this case, companies' real health -- eventually wields its power. In markets, this truth asserts an economic justice that sets prices close to appropriate levels. Investors are slowly gaining the courage to really look at what they own. Reality is creeping over this market subtly as a summer mist, but as inexorably as a glacier. Don't get crushed.