What It Really Means to Sell at 100 Times Earnings

In this uncertain world, an investor's alternatives are vast. Thousands of stocks, thousands of mutual funds and thousands of more esoteric investment options vie for investors' money. By taking their present course, most investors assume what they have chosen is superior. I would guess there is an awful lot of Nasdaq trading that would not even go this deep in logic, but we've been there before, so let's move on.

What does it mean to pay 100 times earnings or more for a stock? In a prior piece on Amazon.com (AMZN), I discussed why a discounted cash flow model -- which underpins most of my investment decisions -- is conceptually the correct tool to value companies whose clarity will not be determined until a much later date. So, for today's column, I will ignore the 136 companies that had $1 billion market caps and less than $25 million in revenue in their last fiscal quarter and stick to companies with reported earnings.

Let's take Cisco (CSCO) as an example. Even the most Jim Grant-like observer has to admit that Cisco management has done an excellent job of recognizing the growth of the bandwidth market. The company has improved employees, products and services to a level that is truly breathtaking.

OK, just showing up, as Woody Allen might say, has clearly helped Cisco, given the enormous secular growth in its markets, but I think you cannot say enough about how well the company has managed its growth. So, naturally, this success is well recognized, and Cisco sells at around 122 times its June 2000 earnings estimate of $1 and at 95.4 times its 2001 estimate of $1.27.

This spreadsheet (Excel file | Acrobat file) helps explain what it means to sell at 100 times earnings.

Compare the alternatives. Choice No. 1 shows what happens if you own 100% of Cisco and it grows 30% per year forever. Thirty percent is an extraordinarily healthy number for a company the size of Cisco and gives any bull on Cisco the benefit of any doubt. That this represents a slowdown in growth from recent years doesn't seem to faze anyone, but I digress. I also simplified the chart by showing net income as a benchmark for cash earnings and assumed that Cisco would keep all the net income and not worry about reinvestment.

Choice No. 2 presents the option of selling 100% of Cisco at its current market capitalization of $390 billion and reinvesting the money in A-rated corporate bonds yielding 7%. Choice No. 3 illustrates the option of selling Cisco and then reinvesting in some sort of old-fashioned equity index fund earning the measly 11% dictated by economist Roger Ibbotson's data on various investment returns.

I then calculated the scenario if 20% were taken off the top for a capital-gains tax, which is only fair since the assumption is that everyone but me owns Cisco at a cost of $1.

So your grandmother, who happens to be a giant tax-exempt entity in this example, opts out of Cisco and decides to take the nearly guaranteed 7%. Even spotting you 30% growth, if she simply reinvests her annual income back at 7%, it will take you roughly 10 years before your beloved Cisco is earning a bottom-line equivalent to the interest income. It takes roughly 16 years before the cumulative numbers meet.

Follow the Leader?
ACTION	Years Until Cisco Income Equals Alternatives	Years Until Cisco Cumulative Income Equals Alternatives
Sell Cisco and invest in bonds	11	16
Sell Cisco and earn 11% in stocks	17	21
Sell Cisco, pay 20% capital gains and invest in bonds	10	15
Sell Cisco, pay 20% capital gains and invest in stocks	16	20

If your grandmother decides to go whole hog and invest in the conservative index fund and earn the 11% we were all taught in school to earn, the numbers get just silly; she is beating you like a gong.

This is another fancy way of suggesting that price has to matter somewhere or somehow. Time and time again, I have seen conventional wisdom be accepted, even though it appears that no one has done the numbers to see if the enthusiasm can possibly be justified. There have been cases -- and some exist today -- where the market cap of an individual player actually exceeds analysts' estimates of the entire industry or marketplace in which it operates. That sure makes for some funny math.

If you happen to have an unhealthy attachment to Cisco, plug in some other numbers. The math against paying 100 times earnings still won't stack up in your favor.

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