Valuing AOL and Relating Bonds to Gold

If there's one thing I've learned about this city so far, it's to expect the unexpected. Just the other day a guy in coveralls walked up to my office window, opened it up, hopped out on the ledge, closed the window behind him and started washing the panes. No rope, no harness, just a six-inch lip of concrete and 140 feet of blustery air between him and oblivion.

In a way, that's how I feel every week here at Fundamental Questions. Without a cushy safety net of reader questions to draw from, I'm liable to pancake on Trinity Place. So keep those emails coming in to me here. I'm also looking for meaty subjects to run a few feature articles and break up the Q&A pace. Enough said. On to the column.

Flunking the Valuation Final with AOL

I would like you to take on America Online (AOL) and the recent rise it has incurred. Do you believe that AOL is extremely overbought or is the price justifiable? Thanks.

-- Robert Saville

Robert:

I guess it all depends on your definition of "justifiable." I heard somewhere about Warren Buffett's plan for a teaching an investment class for budding analysts. For the final exam, he'd ask each student to value an Internet stock. Those who handed in a value -- any value -- would automatically flunk the course and be sent back to remedial studies until deemed fit to rejoin mainstream society.

So from a strictly fundamental perspective, AOL is insanely overvalued. According to guidelines set forth by Ben Graham, the father of stock valuation, you'd need to have your centers of rational thought lobotomized with a knitting needle to ever dream of paying hard-earned dollars for a stock sporting a current price-to-earnings ratio of 656 and a price-to-book of 93 (see my piece Ben Graham's Lucky Seven for more).

Even using more modern valuation methods like Economic Value Added (see my EVA Primer) yields similar results. According to my back-of-the-envelope EVA calculations, AOL would need to lock up and sustain over 1 billion subscribers right now to justify the future growth rate implied in the current stock price.

Keep in mind that fundamental analysis is geared toward wealth builders who want to soberly buy undervalued assets at bargain prices with the intention of holding them for a long time. This kind of rational approach is often at direct odds with the short-term realities of a hysterical market.

After all, over 30 brokerage firms rate AOL a buy and the stock price continues to march higher. So while the stock may seem way overpriced, trying to run against the crowd, even if they're headed for a cliff, could get you trampled in the near term. Or as I heard one tipsy trader announce loudly in a local Wall Street watering hole the other night, "don't fight the tape" -- or was it, "I don't like my date"? Either way, you get the picture.

Price Target Fiesta

Andrew, I found your answer concerning price targets interesting. Tell me, how are price targets determined with Internet stocks that have no earnings and a negative P/E? Is it the "sombrero method"?

-- Mark Dempsey

Mark:

Si amigo. Except with tech stocks, the analysts wear baggy jeans and chug Zima.

But seriously, even cash-burning start-ups are generally predicted to have some positive earnings at some point in the future to justify their existence in the Darwinian market. Analysts can just use these forecasts to peg targets as described previously.

Even without net earnings to use in calculations, analysts are famous for concocting other bizarre ratios to divine price targets based on a "multiple" approach. So your company isn't making any money and isn't predicted to do so anytime in the next decade? No matter in the "new economy." They must be bringing in some kind of revenue, right? Then just take the price-to-revenue (or price-to-sales) ratio as your benchmark and go from there. What if your Net portal wannabe has only scant revenues? How about price-to-readers, or price-to-market share?

Anyway, you get the idea. There's no shortage of multipliers in the carnival sideshow to apply in determining price targets. Whether they're more accurate than the sombrero is anybody's guess.

Tracking the Tracking Stocks

Could you explain "tracking stock"? If the earnings of a tracking stock are transferred to the mother company, why bother having a tracking stock at all?

-- Jeff Koeppel

Jeff:

Why indeed?

Tracking stock is a kind of paper construct used by corporations that lack the gumption to do a full-fledged spinoff of a business unit. The idea is that it gives investors the ability to more easily value a business operation as a separate entity without hassling with the legal and tax considerations of a full-on corporate restructuring.

The problem, as you've so deftly pointed out, is the process fails to really address the underlying considerations like poor investor perceptions or negative operational synergies that may be leading to the poor conglomerate valuation to begin with. As such, it remains a rather unpopular choice on the corporate restructuring menu.

Bonds & Gold

Please comment on the relationship between bond prices (or yield) and the CRB (more specifically gold).

-- Paul Conner

Paul:

In theory, it should be a pretty simple inverse relationship. Gold (and other commodities) generally track inflation. The idea is that in times of increasing prices, you want to grab hard assets that will hold their value instead of hoarding cash, which is losing its purchasing power over time.

Bonds, on the other hand, become less valuable during unexpected increases in inflation. If prices of goods and services are going up, you need a higher interest rate to compensate you for the fact that your principal investment will buy less stuff at a future maturity date than it does now.

So, gold prices up means bond prices down. At least that's how it's supposed to work in the fairy tale realm of theoretical economics. Out in the real world, things get a lot dirtier, so the relationship probably won't hold completely at all times. In general, though, expect to see some kind of inverse correlation over the long run.

Random Musings

Congrats to the NCAA women's basketball champs at Purdue University. It just reinforces the hard lesson I learned at undergrad keggers: There's no putting one over on those corn-fed, farm-raised Lady Boilers.

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