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The classic stock pricing models use the expected value of future dividends plus an expected capital gain to determine a stock's current value. The cash received as a result of owning a stock is totaled up and then "discounted" back to a price in today's dollars. Discounting means you calculate what that future cash would be worth in today's dollars, much like we think of inflation when someone says "a million dollar portfolio when you retire in 2040 will only be worth $209,000 in today's dollars."
Using this classic model, the discount rate is the rate of return you demand as compensation for taking the risk of owning the stock. If you use the classic formula and it churns out a price that is higher than today's selling price, then the stock is a bargain. If it is lower than today's selling price, then the stock is over-priced, according to the parameters you set.
In today's market, many stocks are still valued this way, but the classic models don't seem to apply to many "hot" tech stocks or Internet stocks. This makes some investors understandably nervous. For one thing, dividends are practically nonexistent in the tech stock world. Without a return of cash directly from the company to the investor, you have to assume not only the capital gain from selling the stock, you have to make an assumption about when future dividends will be paid and how high they will be.
That's a lot of assumptions and we haven't even gotten to future interest rates or risk factors, but it still comes down to the idea that a stock is worth the cash you can get out of it plus a "profit margin" to compensate you for taking on risk. (What I am calling your profit margin is more properly called the "expected rate of return.")
Perhaps high tech stock prices are sometimes the result of investors piling on mindlessly expecting to profit simply because they think someone else will pay a higher price later. But in most cases, investors are actually just making some very optimistic assumptions about the future earnings of their company. Those earnings are always the key to stock value.
The venerable Price/Earnings (P/E) ratio prices stocks not in terms of price per share, but in terms of what it cost an investor to buy a dollar's worth of earnings. If the P/E is 15, the price is 15 times the current annual earnings -- a dollar of earnings costs $15. The P/E uses earnings instead of dividends to value stocks, which is not unreasonable because one can assume that eventually those earnings will be returned to the shareholders either as dividends or through the liquidation of the company. Using the P/E for valuation is a convenient and reasonable shortcut to the classic equations.
So how does a stock like Yahoo! <% if gsSubBrand = "aolsnapshot" then Response.Write("(Nasdaq: YHOO)") else Response.Write("(Nasdaq: YHOO)") end if %>, which today has very meager earnings per share and no dividends at all, fit into these models? Well, if Yahoo! is worth the expected future value of its earnings, let's compare it to a company it may imitate, our Foolish Four stalwart, General Motors <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: GM)") else Response.Write("(NYSE: GM)") end if %>.
Good old GM -- there isn't a company around more identified with the United States. (Remember "What's good for General Motors is good for the nation"?) Back in the early part of the 20th century, there were hundreds of competing car companies, but GM was an early leader. It was on the Dow by 1915. At one time, GM was the hottest, newest thing on the block, a participant and leader in an industry that reshaped this country -- and the world.
What Yahoo! investors are saying is that they expect Yahoo! to eventually generate so much profit that today's price will seem "cheap." They expect (some would say that the appropriate word would be "hope") that Yahoo! will turn out to be the GM of the 21st century, the dominant presence on the information highway.
At the end of its first century of operations, GM is a mature business. It's barely growing at all any more. It's had ups and downs along the way, and competition has cut into its share of the U.S. car market, but the company is churning out cash in huge buckets.
Today General Motors is rather out of favor (which is why it's in my Foolish Four portfolio), and it is selling for about 10 times its annual earnings per share. Yahoo! is selling for 540 times its annual earnings per share. Yahoo! is much, much more expensive than General Motors, but, then, Yahoo! is just getting started.
Let's assume Yahoo! really does become the General Motors of the 21st Century. Let's pretend it's 2100 and see what Yahoo! would have to be worth then to justify its seemingly irrational price today.
Valuing Yahoo! at 10 times earnings in 2100 may be something of a worst-case scenario, but it happened to GM so let's run it first. We'll also assume than between now and then Yahoo! has been able to grow its present day earnings of $0.23 per share at 11.35% per year (that's the average compounded rate of return for the S&P 500 for most of the 20th century). At that rate of growth, each of today's Yahoo shares would, at the end of the next century, be earning $10,734, which given a P/E of 10 would make each share worth $107,340. (I think it's safe to assume that the stock would probably split a few more times over the course of the next 100 years, of course.)
Wow, you are thinking, $125 starts to look cheap. In fact, last January's intraday high of $250 looks kind of cheap, you might even think. But that's because you aren't looking very hard. Put that $125 in an S&P 500 index fund. Now compound it for 100 years at 11.35%. You'd have $5.8 million.
Obviously, something is missing here. Yahoo! investors may be optimistic but they aren't crazy. Let's look at the P/E first. A P/E is quite arbitrary. Let's assume that P/E ratios stay high and that even after Yahoo! becomes a very mature company, it still rates a PE of 40. (Some other very old companies, say Coke for example, are selling for even higher P/Es today.) Well, that would translate to a share price of $429,348. That's still not even close to the expected return of an S&P index fund.
The thing is, no one is expecting Yahoo! to grow at an average rate. In fact, it is quite common for young companies to grow at a much faster rate than the economy in general, and a two-stage pricing model is commonly used. Let's use a very generous, in fact almost impossible assumption about the future growth of Yahoo!
Let's assume that it can grow earnings at the fantastic rate of 40% a year for the next 30 years, at which point it will slow to an average of 5% per year for the remainder of the century. The high initial growth rate is wildly optimistic, but that's what it takes to beat the index fund. One hundred years of that kind of growth would make each share of stock worth over $6.7 million. Whoa, that's more like it.
Fantastic as that sounds, it's not unusual for companies to grow like that over long time periods. In You Have More Than You Think, our Gardner bros calculated that $125 invested in Coca-Cola <% if gsSubBrand = "aolsnapshot" then Response.Write("(NYSE: KO)") else Response.Write("(NYSE: KO)") end if %> in 1919 would have been worth over $21 million by the end of the century.
What Yahoo! investors are assuming is that their company will do better than GM --much better. Maybe even as well as Coke. In a weird sort of way, Yahoo! is a lot like both Coke and GM. It's a consumer brand with world changing potential. Maybe Yahoo! investors aren't so crazy after all.
Even so, one doesn't have to assume such a rosy future or take on nearly so much risk when in investing in staid, reliable Foolish Four companies. That's a relief.
Fool on and prosper!