Doug Henwood dhenwood at
Wed Apr 12 13:33:57 PDT 2000

Wall Street Journal - April 12, 2000

Heard on the Street P/Es of Cisco, Others Lead To Stretching of Yardsticks


Analysts are scrambling to find new yardsticks to justify the galloping share prices of technology giants.

Just ask Morgan Stanley analyst George Kelly, who has followed Cisco Systems since it went public in 1990. He has put out a blizzard of research reports during the rapid rise in Cisco's stock, ratcheting up his price targets for the stock in tandem with its ascent.

His method? It's a little like sticking his finger in the air to gauge which way the wind is blowing, he concedes.

"We have to accept the facts of life. If investors want to be in these high-growth companies, we are just trying to take what they are willing to pay and translate it into a target price and therefore a stock recommendation," Mr. Kelly says.

It was once the job of analysts to tell investors at what price a stock should trade. But now, some analysts say investors are calling the shots, even when it comes to big stocks with predictable earnings growth. Sure, the fine art of rationalizing high stock prices has long been on display for tiny, unproven Internet ventures without earnings. After all, it's hard to value a new company using traditional methods when it has no earnings.

But the move to newfangled justifications for the high stock prices of technology behemoths such as Cisco is newer. This time, the excuse isn't that there aren't any earnings to use as a starting point. The result: some interesting mutations in traditional Wall Street theories about how shares of mature companies ought to be valued.

For instance, there's the "peg" ratio. Not long ago, a growth stock was considered fully valued when it reached a peg ratio of 1, meaning that its price/earnings multiple and its earnings growth rate were equal. Nowadays, investors are accepting a much higher ratio for Cisco. Cisco, which fell $2.5625 to $70 in Nasdaq Stock Market trading Tuesday, trades at a peg ratio on next year's earnings of about 4.5, or more than quadruple its roughly 30% growth rate. That's unheard of in previous markets for a seasoned company such as Cisco.

Revenue, once used as a benchmark for measuring only companies with no earnings, is now turning up in analysts' reports as a way to size up Cisco's stock price. Back in the early 1990s, Cisco traded at six times the next year's revenue. Now, it trades at about 25 times.

Meanwhile, Cisco's P/E ratio has exploded. In the fall of 1998, Cisco's stock was valued at 40 times trailing earnings. Now, its P/E ratio is 135 times earnings for its fiscal year ending July 2000. On a trailing earnings basis, its P/E ratio is about 189.

The new yardsticks have been stretched further in recent weeks as investors have dumped shares of tiny Internet companies with no earnings for the relative safety of industry giants with robust earnings.

But now, such rationalizations may come under closer scrutiny. With the recent market turmoil, investors are rethinking whether the valuations assigned to tiny, speculative technology companies ever made any sense. But if the logic behind the run-up in small Internet stocks can be dismantled, what happens to the rationale for Cisco's and other big technology stocks' run-ups? The answer could help determine whether the bull market keeps romping or stumbles again.

"I think it's madness," says Morgan Stanley strategist Barton Biggs, who has been a prominent bear for the past couple of years. "No matter how great the company is, on the basis of rational investing -- not momentum or hope-of-heaven investing -- I don't see how you can make money with a stock that is selling at 150 times earnings and has a market capitalization of half a trillion dollars."

It has never been a winning bet before, at least with a mature company such as Cisco, some specialists say. "In my studies, there has never been a company with a big market value that can justify a price-to-earnings multiple over 100," says Jeremy Siegel, professor of finance at the Wharton School of Business. "In the 1970s, Polaroid came near 95," he says. "But it would have been a horrendous investment if you bought it there," he says.

So far, however, analysts such as Morgan Stanley's Mr. Kelly have been right on the money. Indeed, an investor who followed Mr. Kelly's "strong buy" recommendation back in 1990 and held the stock for 10 years would be up 111,900% on the investment, after nine stock splits. And there is no sign that the momentum-style investing that has carried stocks like Cisco to their current levels is about to change anytime soon.

Even more extraordinary, however, is how readily Wall Street has set down its old tool kit for valuing the shares of big tech companies.

"I spend a good deal of my time talking with investors these days about valuations," Mr. Kelly says. "And it is a bit of an art. But with the stock's P/E ratio above 100, my job is to say how will investors value the stock going forward. How I feel about it isn't important," he says.

Indeed, a look at Mr. Kelly's research on Cisco in recent months provides a graphic illustration of how investors, rather than analysts, are calling the shots on valuations these days.

Nov. 19, 1999 -- Mr. Kelly puts out a note to clients after Cisco's shares hit a price of $44, a 35% gain in just two weeks. "Strong buy," he rates the stock. He raises his one-year price target to $46.50 on a split-adjusted basis from an earlier target of $37.50, saying he believes investors will pay a multiple of 60 times earnings for calendar 2001, or two to 2.5 times its growth rate.

Dec. 2, 1999 -- After Cisco blasts through his price target in less than three weeks, Mr. Kelly boosts his price target to $57.50, saying he now believes investors will pay 80 times 2001 earnings. "Strong buy," he rates the stock. "Fundamentals and long-term opportunity remain strong."

Feb. 14, 2000 -- Mr. Kelly boosts his price target to $75, his third increase in as many months, saying the right P/E ratio is now 111 times calendar 2000 earnings or 100 times 2001 earnings. "We maintain our strong buy," he says.

But, with the focus on what investors are willing to pay rather than what they should pay, is the tail wagging the dog?

Not necessarily, says PaineWebber Group strategist Ed Kerschner. The old rule that a stock's P/E multiple should equal its growth rate doesn't apply anymore, he argues.

So, what's the correct multiple for Cisco? "At 28% growth, Cisco is probably worth 150 to 175 times earnings," Mr. Kerschner says. "I think Cisco looks cheap at these multiples."

Not everyone agrees. Mr. Siegel, for one, says that paying a high multiple of revenue for a new company makes more sense than paying a high multiple of earnings for a company with a solid earnings track record such as Cisco. That's because a small company at least stands a chance of growing at a rate that will satisfy investor expectations, he says.

This time is different, some on Wall Street argue. Yet shouldn't the Federal Reserve's recent move to inch up interest rates put a dent in that theory? No, Mr. Kerschner says. "The multiple isn't keyed off of where rates are today or tomorrow. It's where they will be over 20 years. Longer term, I think rates will be at 5% to 6%" -- about where they are now.

For the time being anyway, Mr. Kelly and other analysts are content to take their cue from investors, who continue to bid up shares of Cisco. Mr. Kelly still rates Cisco a "strong buy," though he hasn't published a new price target since February. During the market turmoil of the past few weeks, Mr. Kelly said he would wait for the dust to settle before publishing another price target on Cisco.

"My one-year price target is a function of a multiple of earnings for 2001 and what investors are willing to pay," he says. "If we wanted to change every time the sentiment about Nasdaq stocks did, we'd be changing it every week," he says.

And that's a lot easier to do when sentiment is bullish.

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