Stretching the figures

200

“Do the math” has become the mantra of a generation of consultants and investment bankers. The new economy, they claim, requires new principles of valuation. But the rules of logic hold even in cyberspace, and so do the principles of economics. Profits are hard to earn in competitive businesses, and markets that are not competitive are usually regulated.

“Do the math”. The slogan comes from Jim Clark, creator of Silicon Graphics, Netscape and Healtheon. It has become the mantra of a generation of consultants and investment bankers. The new economy, they claim, requires new principles of valuation.

C.com is one of the most exciting prospects in B2B commerce. It is the worldwide leader in a growing market – annual sales by 2010 are likely to be around $500 trillion. If C.com can maintain a 5% share, and earn only 1% net margin its prospective annual earnings are $250 billion. If we assume that market growth after 2010 is 5% and discount future revenues at 10%, then the prospective value of C.com is $5000 billion – around ten times the recent market capitalisation of Microsoft, Cisco or General Electric.

You don’t even have to wait for the IPO. You can buy shares in C.com right now for less than 5% of that value. C.com is called Citigroup, and in addition to its foreign exchange trading, which is the business I have described, you get its other wholesale, retail and investment banking activities and a leading insurance company thrown in for free.

Of course, nobody would be so stupid as to value Citigroup in this way. Still, I have followed more or less exactly the methodology recommended in the latest McKinsey quarterly for the valuation of new era companies. They use precisely analogous calculations to arrive at a valuation of $37 bn for Amazon.com.

Paul Gibbs, head of merger and acquisition research at J. P. Morgan, recently used similar principles to confirm that assessment of Amazon. He goes on to do the same calculation for internet service provider Freeserve. Assume that UK retail sales grow at 5% a year, that 25% of sales take place on the net, that portals capture 50% of these, that Freeserve gets 30% of the portal share, and that Freeserve maintains an 8% commission on sales. Multiply all these numbers together and you establish that in 2017 Freeserve will make profits of £2 bn. This, he argues, justifies a market value today of £6.50 per share.

But I prefer T.com to Freeserve. T.com has a customer base four times larger than Freeserve. Its franchise is much stronger, too. Its customers are concentrated in the affluent South-East of England, where it faces virtually no competition. Market research shows that more than 95% of its customers use its services – which are essential – every day, and many of them buy several times a day.

Moreover, T.com has ambitious plans for expansion. At present, its geographical coverage is less than one quarter of the market in England and Wales. T.com has a particular interest in South East Asia. The population of China is one hundred times the number of people who today can access T.com services. Even after the recent market correction, T.com, better known as Thames Water, still has a market valuation below that of Freeserve. At the height of the old economy new economy dichotomy, Freeserve was worth four times as much.

The reason the Citibank calculation is nonsense is simple, but fundamental. The margins Citibank makes on its forex business vary widely. If you buy small quantities of notes from a bank branch, the spread is much wider than 1%. If you are a large corporation trading major currencies, then the margin is wafer thin. Entry and competition force prices in each line of business down to the related costs.

In Mr Gibbs’ model, Freeserve earns profits of £2bn – about equal to the current profits of Tesco, Sainsbury and Marks and Spencer together. And it earns these profits on revenues of only £2.5bn, so that profits are 80% of the value of its sales. No established business earns margins of that size. And for good reasons. If competition doesn’t get you, competition authorities will.

Thames Water is one of a very small number of companies whose market position is so strong, whose output is so necessary to everyday life, that if it charged five times the cost of the services it provides we would have few options but to pay. Still, we do have one option, which is to insist that the government intervenes. And a pretty effective option it is too. It confines Thames Water to a return on its capital employed of around 6%.

The old-fashioned idea that profit is a return on capital invested still has some role in new economy valuation, at the level of the overall market. There is a key formula in the new math. The required yield on a security is equal to the difference between the rate of return demanded from that class of securities and its expected rate of growth. So if you expect a return of 5½% from a share whose dividends will grow at 5%, the dividend yield on it should be 0.5%.

This is exactly the calculation done by Glassman and Hassett in their recent book Dow 36,000 Claiming that sustainable dividends average half of earnings, this yield equates to a market price earnings ratio of 100. That in turn implies a target of 36,000 for the American index.

Investors buying at this level will need to be extremely patient. Only 40% of the cash that sustains the valuation will accrue this century. And one third of it depends on dividend cheques that will be arriving after the year 2200. The Dow Jones index had not been established two hundred years ago. We can visualise the businesses a prudent, diversified investor would then have owned: slave traders and sugar plantations, even a bold speculation in that symbol of the then new economy – the canal.

Perhaps the next 200 years will be more stable than the last, and perhaps Microsoft and Cisco will prove more enduring businesses than canals and plantations. But we can hardly be sure. While 5% may be a reasonable assumption for the growth rate of dividends in the US economy as a whole, it is likely that well before 2200 most of these dividends will come from companies that have not yet been founded – like Microsoft and Cisco only two decades ago.

If that makes us nervous about projections, their sensitivity to assumptions may increase our nervousness. Suppose we accept Glassman and Hassett’s repeated protests that their dividend growth expectations are conservative. If you raise them only from 5% to 5¼, the anticipated value of the Dow Jones index rises to 72,000. At 5 ½% the formula breaks down because the shares of American companies are infinitely valuable. Not even the most credulous dot com investor believes that.

The math works equally in reverse. If expectations of return are 6% rather than 5½%, the perfectly reasonable value of the Dow Jones falls from 36,000 to 18,000. And if equity investors require a return of 8% then you would have to conclude that shares are worth only half their current level.

Now an 8% expected total return is not ambitious for an equity investor. A day trader might think you were talking about a weekly profit rather than an annual one. Glassman and Hassett use a figure as low as 5½% – the return on Treasuries – because they argue that equities have so consistently outperformed bonds that there is now no risk associated with equity investment. In other words, because equities are sure to offer higher returns than bonds, the expected yield on equities should be the same as the yield on bonds. You do not have to be Wittgenstein to spot the flaw.

The rules of logic hold even in cyberspace, and so do the principles of economics. Profits are hard to earn in competitive businesses, and markets that are not competitive are usually regulated. The value of companies ultimately depends on their capacity to generate cash for their shareholders. Distant returns are uncertain. Share prices are very volatile, and investors need to be compensated for the associated risks. These simple truths are as valid in the new economy as the old.

By all means do the math. Isaac Newton, who could do the math better than anyone else in history, gave up an annuity of £650 per year to invest in the South Sea Bubble. In addition to the math, you need the econ, the pol, and perhaps the psychology.

James K. Glassman & Kevin A. Hassett: Dow 36,000: The New Strategy for Profiting from the Coming Rise in the Stock Market Random House 1999

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