The Motley Fool, 9/26/97: The Evening News

UK-based NATIONAL WESTMINSTER BANK <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: NW)") else Response.Write("(NYSE: NW)") end if %> jumped $6 13/16 to $90 5/16 in a strong London market, which gained ground on a Financial Times report that Great Britain will join the European Monetary Union, a move that former Conservative Party Prime Ministers had opposed. The UK's largest bank, BARCLAYS PLC <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BCS)") else Response.Write("(NYSE: BCS)") end if %> also gained $4 13/16 to $106 1/16 on the report, as the Financial Times index (a.k.a. the "Footsie") soared more than 3% on the day and the pound sterling shot up, as well. Traders said this would bring interest rate stability to the EU, which is profoundly mistaken, some believe, because interest rates are set by markets and not mechanisms or high councils. For more on U.K. companies, AOL subscribers might want to give the new Fool UK a visit on this, our first week of Foolery across the pond.

Regional brokerage firm, investment banker, and money manager LEGG MASON <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: LM)") else Response.Write("(NYSE: LM)") end if %> rose $3 1/16 to $53 1/2 as the smaller of such companies (like INTERSTATE JOHNSON LANE <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: IJL)") else Response.Write("(NYSE: IJL)") end if %>) continue to be bid up as part of the financial services consolidation that may mark the 1990s. Legg Mason presents a much more compelling acquisition to a number of banks or even large financial firms such as TRAVELERS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TRV)") else Response.Write("(NYSE: TRV)") end if %>, in part because of the stellar performance of its mutual funds. Legg Mason is valued at 1.4% of assets under management (AUM), compared with 5.5% for FRANKLIN FUNDS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: BEN)") else Response.Write("(NYSE: BEN)") end if %> and 3.5% for T. ROWE PRICE <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TROW)") else Response.Write("(Nasdaq: TROW)") end if %>. Legg Mason's valuation ignores other activities like investment banking and brokerage activities and substantially, possibly unfairly, ignores its $40.1 billion of assets under management with its registered investment advisors.

Financial services companies were hopping today, as the Salomon-Travelers deal fanned the embers of a financial system primed for consolidation. Mutual fund manager and trust company STATE STREET CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: STT)") else Response.Write("(NYSE: STT)") end if %> was bid up $4 1/4 to $59 7/8; investment bank, brokerage, and venture capital company HAMBRECHT & QUIST GROUP <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: HQ)") else Response.Write("(NYSE: HQ)") end if %> gained $2 9/16 to $34 1/8; and regional brokerage and securities underwriter KINNARD INVESTMENTS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: KINN)") else Response.Write("(Nasdaq: KINN)") end if %> jumped $1 1/8 to $7 1/2. Financial Borg MERRILL LYNCH & CO INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MER)") else Response.Write("(NYSE: MER)") end if %> also moved higher in today's action, gaining $3 1/16 to $73 5/16.

Competitive local exchange carrier NEXTLINK COMMUNICATIONS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NXLK)") else Response.Write("(Nasdaq: NXLK)") end if %> popped out of the initial public offering box today, gaining $6 1/4 from its IPO price of $17 to close at $23 1/4. Founded by McCaw Cellular principal Craig McCaw, the company has trailing revenues of $0.70 per share and has run negative gross cash flow of $0.97 per share over the last twelve months. Internet domain name registry NETWORK SOLUTIONS INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: NSOL)") else Response.Write("(Nasdaq: NSOL)") end if %> jumped $5 5/16 from its IPO price of $18 per share, closing at $23 5/16. The company has trailing revenues of just over $2 per share, and while it is a monopoly, has generated net losses of $0.14 per share over the last twelve months. In the last six months, though, earnings have turned positive, with EPS climbing into positive territory of $0.09 per share for the first half of fiscal 1997.

QUICK TAKES: CELLULAR VISION USA INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CVUS)") else Response.Write("(Nasdaq: CVUS)") end if %> jumped $1 1/2 to $8 1/2 after the FCC granted the company an exclusive local multipoint distribution service license (for Internet transmissions and television signal distribution) for the New York City area... FEDERAL MOGUL CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: FMO)") else Response.Write("(NYSE: FMO)") end if %> rose $3 3/4 to $37 1/4 after the auto parts manufacturer confirmed that it has made a $37.72 per share offer to acquire T&N plc, a British "automotive components and engineering group"... Safety systems and defense industry manufacturer TALLEY INDUSTRIES <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: TAL)") else Response.Write("(NYSE: TAL)") end if %> moved $1 1/8 higher to $12 9/16 after agreeing to be acquired by specialty metals company CARPENTER TECHNOLOGY CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CRS)") else Response.Write("(NYSE: CRS)") end if %> for $12 in cash for each common share... CREATIVE TECHNOLOGY <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CREAF)") else Response.Write("(Nasdaq: CREAF)") end if %> gained $3 3/4 to $27 11/16 after Goldman Sachs upgraded the maker of SoundBlaster sound cards and multimedia cards for PCs to "trading buy" from "market outperform"... Biopharmaceutical products company IMMUNEX <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: IMNX)") else Response.Write("(Nasdaq: IMNX)") end if %> rose $6 3/8 to $66 1/8 after announcing an agreement with pharmaceutical company AMERICAN HOME PRODUCTS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: AHP)") else Response.Write("(NYSE: AHP)") end if %> to promote Immunex's treatment for rheumatoid arthritis, under which Immunex will receive up to $100 million in milestone payments... Online auction and direct marketing company ONSALE INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ONSL)") else Response.Write("(Nasdaq: ONSL)") end if %> rose $3 5/8 to $31 1/4 on signing a marketing agreement with Computer Shopper NetBuyer from ZDNet.

Back to the UK we go, where British/Dutch publishing and information services company REED INTERNATIONAL PLC <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: RUK)") else Response.Write("(NYSE: RUK)") end if %> dropped $3 7/8 to $34 7/8 after revealing "irregularities" at its Reed Travel Group unit. The company said the irregularities in circulation statements go back to 1991, suggesting that the company might have been overstating the readership of its travel and hotel guides. As such, the company said it will take a "substantial writedown" of intangible assets, according to Reuters. If those assets are in the form of goodwill, misrepresentation of subscriber numbers to pump up advertising revenues over a number of years would certainly hurt the value of that goodwill.

Programmable logic device (PLD) company LATTICE SEMICONDUCTOR <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: LSCC)") else Response.Write("(Nasdaq: LSCC)") end if %> slid $4 7/8 to $64 1/2 after UBS Securities lowered its rating on Lattice to "hold" from "buy" based on the analyst's belief that the market is soft for its products and on valuation of the shares. The downgrade follows a $9+ fall less than a month ago in the shares of PLD company ALTERA CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ALTR)") else Response.Write("(Nasdaq: ALTR)") end if %>. Altera said the North American market consumption was soft, meaning its customers might have some inventory clogged up in the channel. XILINX INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: XLNX)") else Response.Write("(Nasdaq: XLNX)") end if %> also fell when Altera issued its guidance. ACTEL CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: ACTL)") else Response.Write("(Nasdaq: ACTL)") end if %> dropped $1 11/16 to $19 5/8 today despite coming off a quarter in which its sequential revenue gains were not as strong as its competitors', suggesting its customers might not be in the same inventory position as other PLD fabricators.

QUICK CUTS: PLUMA INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: PLU)") else Response.Write("(NYSE: PLU)") end if %> was sheared for a $3 3/8 loss to $10 after the maker of fleece activewear announced that it is expecting flat year-over-year Q3 revenues and EPS as low as $0.20, missing the mean First Call estimate of $0.51... program management and consultant firm MAXIMUS INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MMS)") else Response.Write("(NYSE: MMS)") end if %> was crushed $1 11/16 to $29 1/4 today, feeling the after effects of a downgrade from "buy" to "market perform" from DLJ... BIOCRYST PHARMACEUTICALS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: BCRX)") else Response.Write("(Nasdaq: BCRX)") end if %> lost $3 1/4 to $6 1/4 after Phase III trials of the company's topical cream for "cutaneous T-cell lymphoma and... psoriasis showed 'no statistical differences' between those treated with the BCX-34 cream and placebo groups."... Local area networking (LAN) support provider company TECHFORCE CORP. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TFRC)") else Response.Write("(Nasdaq: TFRC)") end if %> plunged $3 1/8 to $8 on announcing that it will miss Q3 and full year 1997 earnings estima tes because of lower hardware sales, increased operating expenses, and expenses the company will incur to exit its FedEx repair business... Semiconductor maker BENCHMARQ MICROELECTRONICS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: BMRQ)") else Response.Write("(Nasdaq: BMRQ)") end if %> was taken down $9 to $24 1/2 after the company said it expects a 10% sequential decline in revenues and earnings due to lower sales of its nonvolatile SRAM products... photolithography laser company CYMER INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CYMI)") else Response.Write("(Nasdaq: CYMI)") end if %> continued its decline today, moving $4 1/2 to $25 1/2 after a Morgan Stanley downgrade from "strong buy" to "neutral"... digital video systems manufacturer MEDIA 100 INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MDEA)") else Response.Write("(Nasdaq: MDEA)") end if %> dropped $5/8 to $6 after reporting a 3Q loss of $0.05 after a restructuring charge, versus expectations of $0.02... TRIMBLE NAVIGATION LTD. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: TRMB)") else Response.Write("(Nasdaq: TRMB)") end if %> fell $1 3/8 to $19 1/2 after the maker of global positioning system receivers warned of a delay in shipments to the U.S. military due to slower-than-expected testing an
d review for its Cargo Utility products.

[Editor's note: This is a revisitation of a Fool on the Hill from August 9th, 1996, with significant new material added.]

The Fool Ratio, or PEG, is a pragmatic tool. Rather than being saddled with all sorts of questionable academic baggage, it represents an investor's attempt to cut through the baloney and develop a "do what works" approach. Does history and idiosyncratic experience imply that the P/E-to-Growth Ratio (PEG) works? If so, then use it. As many an over-complicated investment approach has proven, much teaching offers little understanding. However, for many more mathematically inclined investors, this admonition to "do what works" has never been satisfying. They want to see a derivation of the PEG from some other accepted formula, perferably using calculus.

Simply put, people put too much stock in formulas. However, it is important to understand conceptually why the PEG works. Anyone at all familiar with the idea of valuing investments via the discounted cash flow (DCF) methodology will intuitively understand that the PEG works because it offers a truly comparative way to see how much the market is discounting future cash flows. Discounted cash-flow analysis attempts to reduce all future estimates into current dollars, using whatever discount rate has been deemed acceptable. The PEG tells you how much the future cash flows are worth relative to the current cash flows, taking the estimated rate of growth as the discount rate.

Almost axiomatic for students of valuation is the idea that the the current share price tells you how much the market is currently valuing the "discounted" future cash flows. Valuation measures like the price/earnings ratio, the price/sales ratio and the like exist to give you a sense of how much the future cash flows are being valued at relative to current cash flows. As the valuation gets lower, it means that the discounted value of the future cash flows gets closer to the current value of the cash flows. What makes a company valuable is not what it has earned, but what it will earn in the future. The current share price should be based on the value of the income stream you as a shareholder are entitled to, not what the company has already done.

Discounted cash flow (with "cash flow" better known as earnings before interest, taxes, depreciation and amortization, or EBITDA) is the way that almost every business school graduate is trained to evaluate business opportunities. This EBITDA for many companies is "substantially similar" to accounting earnings, meaning that when you are working with future earnings, you are working with estimates of the future cash flows. All you need is a mechanism that discounts these cash flows back to their present value and compares them to the current rate at which those cash flows are being valued and you will have a quick shorthand for whether or not the company might pose a compelling investment opportunity. The PEG does just this.

Any investor who focuses on earnings has probably heard this phrase before: for many companies, earnings are a good proxy for cash flow. Because most "growth" companies in the late 20th century lack substantial depreciation, amortization or cash-eating capital expenditures, the "D" and the "A" of EBITDA can be tossed out. Since almost all companies run relatively debt-free, as debt has been out of favor since the late '80s after the leveraged buy-out backlash, "I" is not especially relevant, either. Finally, taxes pretty much affect all whitebread "growth" companies equally, making "T" something you can figure affects all companies in a similar fashion. Net any changes in the company's working capital like inventories, receivables and the like, accounting earnings really do roughly approximate cash flow for companies that do not have significant interest, tax, depreciation or amortization issues.

For companies where this EBITDA is substantially similar to earnings, by comparing the P/E and the growth rate you compare the rate at which the discounted cash flows are being valued with the rate at which they will grow. The P/E takes the price and relates it to the trailing twelve months' earnings. The growth rate turns those earnings from yesterday into earnings tomorrow, or estimates of future growth, and is derived by taking future earnings, or E(1), and relating them to current earnings, or E(0). When you take the P/E and divide it by the growth rate, you effectively compare the valuation of the cash flows with their growth rate, as follows:

       P/E      Price/E(0)   Price    E(0)    Price
PEG = ------ = ----------- = ------ * ---- = --------
      Growth    E(1)/E(0)     E(0)    E(1)    E(1)

COREL CORPORATION <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: COSFF)") else Response.Write("(Nasdaq: COSFF)") end if %>
(416) 626-4100 (code: 633413) -- replay

CABLETRON SYSTEMS <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: CS)") else Response.Write("(NYSE: CS)") end if %>
(402) 220-4881 -- replay through 9/29

COGNOS INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: COGNF)") else Response.Write("(Nasdaq: COGNF)") end if %>
(800) 997-6906 -- replay through 9/30

09/30/97 (Tuesday)
CANANDAIGUA BRANDS, INC. <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: CBRNA)") else Response.Write("(Nasdaq: CBRNA)") end if %>
(800) 964-3296 -- replay through 10/2

3COM <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: COMS)") else Response.Write("(Nasdaq: COMS)") end if %> Call
MICRON ELECTRONICS <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: MUEI)") else Response.Write("(Nasdaq: MUEI)") end if %> Call
MICRON TECHNOLOGY <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: MU)") else Response.Write("(NYSE: MU)") end if %> Call

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