False Hopes for Sky-High Growth Linger in Tech Valuations
Many of last year's tech darlings may never return to the promised land of high growth, where earnings rise at a steady clip of 20% or more a year. But long-term growth forecasts and price-to-earnings ratios don't reflect that.
History shows that breakneck earnings growth in the tech sector, inspired by booming demand for new technologies, eventually tapers off as businesses mature. The high-growth businesses become cyclical -- or sensitive to changes in the economy. This transformation implies a decline in growth rates to about 10% to 15% from 20% to 40%. And lower growth means a lower premium.
A look at a few classic cyclical sectors in the
S&P 500 reveals what kind of multiples investors are willing to pay for 10% to 15% earnings growth. The
S&P 500 Basic Materials Index
holds a long-term growth forecast of 10% and a trailing P/E of 21.3, while the
S&P 500 Consumer Cyclicals Index
has a long-term growth forecast of 15% and a P/E of 22.3. By comparison, the
S&P 500 Technology Index
is valued at 30.5 times earnings.
Take
Cisco
(CSCO) - Get Report
. The networking giant, which controls more than two-thirds of the global market for routers, has seen earnings grow at a steady clip of 31% over the past five years. But the company has lowered its guidance dramatically during the past two quarters and analysts are now projecting a 23.5% decline in earnings this year. Yet Cisco is seen recording year-over-year earnings growth of 25.4% during the next three to five years, and it maintains the P/E ratio of a growth stock -- 39.2.
There's no guarantee Cisco will actually fall short of these long-term forecasts, but historical research shows that just one in eight companies is able to sustain growth rates of above 20% over a 10-year period and that the average life span of a tech company is only four and one-half years, says
Sanford Bernstein
analyst and strategist Vadim Zlotnikov.
Meanwhile, Cisco's case is far from the most extreme. Long-term forecasts for many tech stocks are way out of line with current year estimates -- as much as 100 percentage points in some cases -- and the current year numbers continue to fall. Such disparities ought to raise a red flag for investors, experts say.
"These growth rates say, yes, these are still growth companies, when really they should have the P/E ratios of somewhere between
General Electric
(GE) - Get Report
and
Caterpillar
(CAT) - Get Report
," says Jim Bianco, president of
Bianco Research
. "Cisco has become an economically sensitive consumer stock. You would need to take it down another 70% to get it to fair value."
That would amount to some serious damage in a tech sector where many stocks have already lost half or more of their value over the past year. Cisco has fallen 75% from its peak of $79 last March to around $20 today. Another 70% drop would put it at $6.
While it's widely accepted that the
PC sector has already been demoted to cyclical from growth status, the communications equipment, storage and Internet sectors are also prime targets, says Zlotnikov. But even now, PC maker
Dell
(DELL) - Get Report
is valued like a
high-growth stock, with a price-to-earnings ratio of 31.
"There's one area where this transition has already occurred, and that's PCs," said Zlotnikov. "But from an industry perspective, any area which has a very high multiple and trades as a growth stock is susceptible." Communications equipment is the area that's most vulnerable to lose its growth status now, according to Zlotnikov, because capital spending by telecommunications companies has simply run out of steam.
"Spending by telcos on capital equipment has been growing as a percentage of cash flow for the past 15 years, so you could grow much faster than your end markets," he said. "Now that the telcos are spending over 100% of cash flow on capital, you simply can't grow much faster than cash flow."
A look at one telecom equipment name paints a pretty dire picture.
Broadcom's
(BRCM)
share price would probably be halved to $18 if its long-term growth rate were to fall to 15%. Analysts expect the communications chipmaker to grow 45% over the next three to five years, and the stock carries a price-to-earnings ratio of 37.8.
One way for investors to check for companies most likely on the verge of morphing from a growth stock into a cyclical is to screen for stocks with the widest disparities between current-year forecasts and long-term forecasts. It's by no means a foolproof test, but it's a good place to start. Some nontech names are also on the list, and while it isn't necessarily a reflection of the shift to cyclical from growth, it may also be a warning sign.
Of course, some investors -- especially professional investors -- know long-term forecasts aren't totally reliable. But they're important in that they help investors assign growth categories to stocks, and thus drive valuations. Many investors rely on long-term growth forecasts to calculate valuations through ratios --
price-to-earnings-growth figures.
And those who like to buy a stock and hold it for a long time are likely to look further out on the horizon -- whether high-octane growth recovers now or later is less of a concern than whether that growth will recover at all.
Those betting on an earnings recovery some time at the end of this year may be expecting technology earnings to return to business as usual. In the meantime, long-term growth rates may have to come down.
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