You can sense the frustration RBC Capital analyst John Wilson feels when you read his recent report on Nortel Networks. Perhaps you've even felt twinges of that frustration yourself, as you watch the stock rise despite the fact that it is miles away from any reasonable value based on fundamental benchmarks -- even fairly optimistic ones. Hence the title of Mr. Wilson's report: "Stop Pulling Your Hair Out . . . Maybe Valuation Just Doesn't Matter." But is that the best advice for investors?
It's important at this point to distinguish between "investors" and "traders." Theoretically, at least, investors are supposed to be putting their money into stocks after some kind of analysis of a company's prospects, sales, market share and so on -- analysis they have either done themselves, or had done for them by a financial adviser. The idea is that someone has tried to apply a few rules to determine where the stock price should be and compare that with where it is.
Traders, on the other hand, couldn't give a tinker's damn about valuation methods based on fundamentals. All they care about is whether the stock is going up -- whether it has "momentum." Obviously, some stocks fall, as Nortel and Research In Motion both did in 2000; but then they eventually go back up again. And how can you tell when they are going to go up again? Simple -- they start going up again. If you like the slot machines or the race track, this is for you.
There's a middle path between these two approaches that some investors and analysts take, but in a way it's the least defensible of all. It involves using the standard stock valuation benchmarks, such as price-to-earnings, price-to-book-value and price-to-sales -- but in such a distorted way that they have only a tenuous relationship with reality. For example, some analysts say RIM's stock price is justified because it's only 50 times the discounted profit it might make in 2006 or 2007.
Despite what some people choose to believe, debating the value of Nortel's stock -- or that of Research in Motion, or anyone else for that matter -- doesn't mean you don't "like" the company, or that you want to see it fail. Investing isn't supposed to have anything to do with "liking" a particular company. It's supposed to be about the process of arriving at a reasonable valuation for a stock, so you can tell when to buy or sell it.
It's not like there aren't any recent examples to point to when it comes to the dangers of throwing rational valuation methods out the window -- the Internet stock frenzy of the late 1990s should have a special place reserved for it in any study of investment mania, right up there with tulip bulbs. Investors became so irrationally attached to certain stocks that they put faith in unbelievable growth stories and decided that valuation didn't really matter.
That's why the impulse behind a report like Mr. Wilson's may be understandable, but the implications of it are unfortunate. To be fair to the analyst, he doesn't say all valuation methods should be thrown out. He simply points out that based on Nortel's track record, its ratios (price-earnings, etc.) continue to rise so long as its revenue is rising, regardless of whether they seem rational or not.
As Mr. Wilson notes, telecom equipment stocks have seen a massive rally over the past year, with the biggest laggard up over 100 per cent and the best -- Nortel -- up over 1,000 per cent. Although sales have risen and profitability has improved, the main thing that has happened is investors have shown they are willing to pay higher and higher multiples. According to RBC, multiples of "enterprise value" (market value minus liabilities) to revenue are now anywhere from three times to 10 times as high as they were a year ago.
Obviously, the fact that the telecom equipment market appears not to be shrinking anymore (or at least not as quickly), and that firms such as Nortel managed to escape bankruptcy means they are definitely worth more than they were a year ago. But how much more? That's the hard part. Research in Motion is another good example. Its growth in the past few quarters has been stronger than expected --- but how much should investors pay for that? At the moment, it's about 80 times projected earnings for this year.
Using fundamental valuation, RBC arrives at a $3 (U.S.) price target for Nortel, which explains the firm's "sector perform" rating, since the stock is over $4. Even assuming a 25 times price-earnings multiple on future profits doesn't get Nortel to $4 - for that, you need to assume 30 times projected profit for 2005. Meanwhile, Verizon and Level 3, two big U.S. telecoms, have both lowered their spending targets for the year, and the industry is expected to shrink again next year. If you assume multiples will continue to expand anyway, however, you can justify a Nortel price as high as $7.
So which are investors supposed to believe? That depends a lot on whether they want to be investors or traders. It's not that one is better - but you should know which one you want to be going in.
- Report on Business Company Snapshot is available for:
- NORTEL NETWORKS CORPORATION