Dateline: 9/14/98

A few years ago I was contemplating buying a business. The idea of being my own boss had always appealed to me. That, coupled with corporate downsizing at work, a tight family budget, and a need to expand our income, made it seem like a good idea at the time.

After checking out a few opportunities in the trade papers, I decided to drop in on a millionaire friend to ask his advice. What he said made good sense, not just for buying a business, but also for buying stocks. He said "Don't buy good will. Look for a business for which the asking price reflects the value of the business's assets. Good will is just so much smoke."

Last week I discussed the Q-ratio. This concept, developed by Nobel economist James Tobin, says that the combined value of all the stocks on the market should be roughly equal to the replacement cost of those companies. Thus the ratio of market capitalization to replacement cost, the Q-ratio as he called it, should be one. As I pointed out last week, the Q-ratio is currently over 2. In other words, there's a lot of smoke out there!

Another measure of a company's value, one more widely known and used, is the price to earnings ratio, or P/E. This ratio reflects the market's estimation of a company's future earnings discounted for risk and time. So if a company's earnings per share are $5 and its share price is $100, it's P/E ratio is 20.

If profits are growing exponentially over time, like the profits of Microsoft, Intel and Cisco have been doing over the last decade, the share price grows exponentially as well. The P/E of such companies tends to be high if the market expects their profitability to continue to increase at a good rate.

On the other hand, a company with stable year to year profits and no growth, would have a much lower P/E reflecting this fact. And if profits are shrinking then the P/E multiple would be lower still. If a company is, in fact, losing money, then you cannot calculate a P/E ratio at all. The share price represents the market's estimations of the prospects for a turnaround to profitability (i.e. - is based on projected future earnings).

In today's market there is another phenomenon. The company with no earnings yet, but for which people have high expectations. This is what is sometimes called a concept stock. Typically these run up fantastic valuations on little or no earnings. Internet stocks are the best example of this.

While the P/E ratio cannot be used as an absolute determinant of whether a stock is overvalued in itself, some analysts like value investing guru Benjamin Graham have maintained that cautious investors should avoid stocks with a P/E over 20 based on the previous year's earnings or 25 based on the average of the previous seven years.

Geoffrey Moore, author of The Gorilla Game argues that this doesn't apply to what he calls gorilla stocks, the high tech movers and shakers like Microsoft, Intel, Cisco, SAP and others, which employ discontinuous innovation and proprietary open architectures with high switching costs. These stocks are different.

But where Moore and Graham both agree, is that conservative investors should look at earnings history in determining whether a stock is worth buying. Clearly, the go-go Internet stocks do not qualify. Such investments are based on what my friend calls smoke. They do not mirror the company's real value.

In the September 7th Barron's, super bear David Tice, the man behind the Prudent Bear Fund, lists five 6 stocks he considers grossly overvalued. Number one among these is Amazon.com, now trading at $76. Tice says its a great company with only one problem - no profits! His prediction - it will end up below $10. Tice also thinks Intel is over-rated and predicts it will drop from its current price of $84.94. Moore disputes this however.

A Canadian example of a stock gone to bizarre valuations as a concept stock is Ballard Power Systems. It's dropped from a high of $62.62 earlier this year to its current price of $29.95. Back in June when I did my piece on The Gorilla Game it was running at a P/E of 1400. Today its P/E is still a hefty but more reasonable 80.9. While the concept of an alternative to the internal combustion engine is interesting, and in today's environmentally senstive environment, potentially explosive - the company's future success depends on a massive change in infrastructure. It's a stock to buy as a speculation, not an investment.

Today we are on the verge of a potential bear market. Barron's Jacqueline Doherty puts it squarely. "All told, there appears to be a lot more downside risk than upside potential." Now, more than ever, it's caveat emptor. Watch out for the smoke and look for stocks that reflect real value.

Disclaimer: As with all my columns here, I should re-iterate a precaution. I am not a professional financial advisor. I am a financial journalist and editorialist. The views in these columns are my personal opinions. The author holds interests in a number of the funds mentioned in this article.

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