2002Beat Reporting

How Did They Value Stocks? Count the Absurd Ways

By: 
Gretchen Morgenson
March 18, 2001

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It has now become painfully clear, and last week's gyrations only added more proof, that Wall Street is a different place than it was even a short time ago. A brutish, bearish market has brought with it deflated hopes and new realities.

Among the harsh realities one stands out. Of all the hot air generated during the great bull market of the late 1990's, none propelled stock prices further than the notion that new economy stocks were a breed apart and should not be held to stringent, old economy investing standards. Internet companies and cutting-edge telecommunications concerns, after all, were revolutionizing the world. So, the thinking went, their share prices deserved equally radical valuation methods. Out went traditional methods used by securities analysis that prized earnings. In came freewheeling measures of worth, like revenue growth, Web site traffic and even customer "share of mind."

"The view was, `We've got a new technology, therefore it's perfectly okay to have a new way of approaching the income statement and balance sheet,' " said Anthony Maramarco, a portfolio manager at the Babson Value Fund in Boston. "But sooner or later you have to generate cash and if all you're doing is using cash, you can only play that game for so long."

That game, as investors are learning to their extreme distress, is definitely over. When stocks were galloping ahead, investors were happy to take their eyes off earnings and seize instead upon surging "page views" to justify high stock prices. Who needs positive cash flow when the numbers of "engaged shoppers" are flying? Why bother with the ways of Graham and Dodd, the classic value-hunters, when Wall Street was offering investors the lure of new investing metrics?

Henry Blodget, Merrill Lynch's celebrity Internet analyst, may have put the new economy view best on Jan. 10, 2000, when he wrote in a report, "Valuation is often not a helpful tool in determining when to sell hypergrowth stocks." Mr. Blodget was referring specifically to Internet Capital Group, an incubator of Web companies that was trading at $173.88 then -- and $3 a share now.

Jack Ciesielski

Investors are partly to blame for not wanting to live with what the earnings were telling them," said Jack Ciesielski, an accounting expert.

But he could have been discussing any one of the many highflying stocks that caught investors' fancies.

In their infatuations, perhaps the biggest mistake investors made during the bull market was to believe corporate propaganda about which numbers supposedly provided the best window on the state of their operations.

"Public relations is driving financial reporting," said Jack Ciesielski, publisher of The Analyst's Accounting Observer newsletter, and president of R. G. Associates, in Baltimore. "Everybody's picking the metric they will be judged on. But investors are partly to blame for not wanting to live with what the earnings were telling them. It sounds lame or unhip but, if the earnings aren't there, why grasp at straws?"

Now, with the prices of almost all these former highfliers in the cellar and the overall stock market deep in bear market territory, investors are seeing how wrong they were to ignore excessive valuation levels and to buy stocks based on ephemera like "engaged shoppers" or so-called pro forma results. Suddenly, new economy rationalizations to buy stocks look as ludicrous as the old economy measures looked hopelessly quaint a year ago. Shellshocked investors -- who have lost almost $4 trillion in market value since a year ago -- are wondering just what hit them and how to pick up the pieces.

Survivors of previous market fads that fizzled have some advice. The best thing investors can do to keep their portfolios safe from future devastation, they say, is to learn from their mistakes. Only by understanding how they allowed themselves to embrace the new economy valuation fad can they inoculate themselves from such ills in the days ahead.

Lesson One is as simple as caveat emptor: when investors rely on others for investment research, they must be extremely careful. Since the analysis provided by most big brokerage firms is tainted by their use of upbeat research reports as magnets for investment-banking deals, the painful truth is that investors who buy and sell individual stocks have to learn to do some of their own research on companies to judge their results and their prospects. Just in time for annual report season, stock investors have to go back to perusing balance sheets and income statements.

There ought to be a law in this country that before you're allowed to buy a stock you have to be able to read its balance sheet," said Bill Fleckenstein, a money manager at Fleckenstein Capital in Seattle. "That's where companies try to hide everything. That's where all the shenanigans show up."

A close scrutiny of balance sheets was decidedly missing during much of the late-1990's bull market, even in many Wall Street analysts' reports. As a result, many investors missed such warning signs as bloating inventories and rising accounts receivables that foretold a slowdown in sales at many technology companies. These included Gateway, Cisco Systems, Nortel Networks and Alcatel.

Steve Galbraith, an equity strategist at Morgan Stanley Dean Witter, said that in the final years of the technology stock boom, equity investors took on the role of financing fledgling companies -- early in their development -- that venture capitalists had traditionally assumed. Normally, companies cannot go public without a track record that proved their ability to turn a profit.

Not this time around. "The entire seasoning period for relatively high- risk equity investments was condensed into months, not years," Mr. Galbraith said. As a result, in the first quarter of 2000, fewer than one in five companies that made initial public stock offerings had profitable operations. In 1995, almost two- thirds of new issuers were profitable when they took their stocks public.

Another measure of how willing many investors were to suspend their disbelief during the mania was the period in 2000 during which the more money a company lost, the better its stock did, while the more money a company earned, the worse its stock fared. Think Amazon.com and Priceline, all of which took pride in the amounts of money they were spending.

Just as investors felt that earnings were no longer a necessary ingredient for stocks to steam skyward, neither did they find reason for concern when companies appeared to be burning through their cash. On July 12, 2000, for example, Michael Parekh, an Internet strategist at Goldman Sachs who oversees a group of analysts that cover 60 Internet companies, including Inktomi, DoubleClick and AOL Time Warner, wrote a report arguing that the cash burned by dot-com companies was "primarily an investor sentiment issue" and not a long-term risk for the sector.

Eight months later, a lack of cash has brought about the demise of hundreds of Internet companies and has hammered the results of leading companies like Yahoo. Mr. Parekh was correct that it was not a long- term risk for the sector. As it turned out, it was an immediate risk.

Mr. Parekh said on Friday that the slowdown in the economy that followed his July report suddenly changed the entire picture. "Cash burn is a critical issue for us and it is not a metric we ignored," he said. "But we've had a whole new set of issues around the economy which temper the pace at which traditional companies are spending on technology. These companies were making progress in the third quarter, then on top of that the universe of all these companies got hit by the economy slowing down."

Of course, analysts like Mr. Parekh cannot be held entirely accountable for the money investors have lost in new economy stocks. Investors themselves must take responsibility for succumbing to a market fad. After all, they allowed themselves to be convinced that these companies were in fact different from traditional concerns and should be subject to less-stringent valuation standards.

Every bull market has its own peculiar investment fad, of course. In the great one of the 1960's, for example, the conglomerate was king. Companies like Litton Industries and Textron thrived by swallowing up other companies on the theory that owning different kinds of businesses with different business cycles would protect them from downturns in the economy.

Between 1966 and 1969, when the ardor for conglomerates was at its height, investors believed that their share prices could never fall. Then, in 1970, they plunged, and with them went the conventional wisdom.

More recently, the investment fad was to justify exorbitant prices of technology stocks based, in part, on a litany of so-called nonfinancial metrics. These included customer loyalty, Web-site traffic and "engaged shoppers." Never mind that none of these translated into profits or even, in some cases, revenues.

Mary Meeker, a star Internet analyst at Morgan Stanley, was among the many Internet and technology analysts citing upbeat "usage metrics" as reasons to buy stocks. In a report on drugstore.com published in October, Ms. Meeker cited the company's popularity as a Web shopping destination as a reason to own the stock. She noted that page views per user per month rose to 14.9 in the third quarter, up from 12.5 in August. Then she pointed out the superiority of drugstore.com to competitor PlanetRX's monthly page views of 10.3 as an indication that drugstore.com customers were more satisfied.

"Additionally," Ms. Meeker pointed out, "drugstore.com maintained a level of 48 percent engaged shoppers (a unique user who views at least three minutes of content within the category) ahead of PlanetRx, which had 45 percent." No mention of whether an "engaged shopper" ever became a spending shopper. Drugstore.com recently traded at $1.16, down 54 percent from its price when Ms. Meeker penned her report. (PlanetRx, which Nasdaq has de- listed, is trading at 29 cents a share.)

Last week, Ms. Meeker explained that her use of nonfinancial metrics began back in 1993 with Intuit and AOL and had proved, in those cases, to be a fine way to measure future performance. Both companies lost money initially on their customers, but Ms. Meeker said she thought that if they kept their customers happy they could expand their customer base. And that would in turn drive revenues and, later, earnings. She was proven right.

"The value of a business is its future cash flows," Ms. Meeker said. "The challenge is figuring out what those future cash flows are. If a company wins in its marketplace, if the market is attractive enough and big enough, and if we can find the company that is going to be a leader, the challenge is to find out how customers can be monetized."

About drugstore.com, Ms. Meeker said the jury was still out. "These things take a long time to evolve," she said. "If there is a health and beauty market online, we think drugstore will be a leader. If there isn't, the stock will continue to be a disappointment."

Wall Street analysts were not the only ones citing nonfinancial metrics as key to investors. Last year, in its Global Online Retailing Report, Ernst & Young tried to identify performance measures most valued by e-commerce investors. The study of 31 public companies spanned 18 months, beginning in early 1999. In the second quarter of 2000, Ernst & Young found that investors were concentrating on two factors: gross profits (earnings before many expenses like depreciation and interest costs) and total Web-site visits. Net income, perhaps because so many e- commerce companies had none, was not relevant.

Another nonfinancial metric was the so-called share of consumers' minds that a company demonstrated. Homestore.com, for example, had a "leading mind share among consumers" according to a Morgan Stanley research report dated Oct. 20, 2000. The proof for this claim was that approximately 72 percent of the total time spent by Internet users on real-estate-related Web sites in September was spent on Homestore's properties.

But having a leading mind share could not keep Homestore.com's stock from sliding 26 percent to $19.31 since that report.

Ms. Meeker said: "On Homestore.com, our point of view is that many people will look for homes online and Homestore will be in a leading position. We're willing to make a bet that they will be able to monetize those users."

Mr. Ciesielski, the accounting expert, said investors' interest in nonfinancial information was not detrimental when combined with financial analysis. The problem is, during the Internet craze, investors weighed the nonfinancial data too heavily, he said. 'I used to cover railroads and airlines, and they used to have this wonderful nonfinancial information every month about miles traveled or carloads loaded," Mr. Ciesielski said. "Analysts looked at that, but just to reinforce where earnings were going to go. They weren't grasping at straws. If carloads were going down, you knew earnings were going down."

Although many chastened investors have sworn off the use of Internet page views or engaged Web shoppers to help them make their stock picks, another bull market promotional practice by corporations continues apace even after the bear has awakened. That is the peddling of so- called pro forma numbers, which eliminate pesky expenses from a company's results and make earnings look better. Using Alice-in-Wonderland explanations, new economy companies said that for them these figures better reflected their operating results than those arrived at using generally accepted accounting principles.

How pro forma earnings are conjured varies by company, but often excluded are line items like interest expenses and payroll taxes, thus burnishing the company's results.

Asking investors to ignore these costs -- which the companies must pay in cold, hard cash -- is asking them to accept a fiction about a company's results.

In the old days, companies would include pro forma numbers in financial statements after an acquisition to reflect how the two newly combined companies would have performed if they had been joined for the entire year before the merger. Now, pro forma numbers mean something much more sinister and are becoming practically ubiquitous. Anyone interested in the traditional earnings number has to dig deep into the press releases.

To measure how common pro forma numbers have become, investors can search the Web sites of BusinessWire.com or PRNewswire.com to find companies using them. In a three-day period alone last week, a search on PRNewswire produced 36 citings of pro forma figures.

Companies accentuating the positive through the use of pro forma numbers include Palm, Intel, Yahoo and Cisco. More obscure companies that do so include Stanford Micro Devices and Engage.

At Yahoo and Cisco, for example, pro forma operating income meant excluding the expense of payroll taxes. At Level 8 Systems, a software provider, a net loss of $4 million in the third quarter last year was transformed into pro forma net income of $1.8 million by adding back noncash charges like depreciation and amortization of intangible assets.

The creativity goes on and on. Mr. Ciesielski thinks that the vast number of corporations using pro forma figures have made earnings releases increasingly dubious. "The whole concept of what's earnings and what's on the cash-flow statement has become so bastardized that nothing makes much sense any more," he said.

Investors can thank the raiders of the 1980's for the current love affair with pro forma numbers, Mr. Ciesielski said. "Back then, people would look at companies with ugly earnings, but they had good cash flow underneath because depreciation was big," he said. The leveraged buyout boom, he said, "was largely fueled by amateurs trying to find companies with big depreciation charges."

"And in the 90's, we all jumped on that, taking out the parts we didn't need to prove our point," he added.

Mr. Ciesielski advises investors to pay no attention to pro forma numbers and to do their own math to find out where companies really stand.

Byron Wien, chief United States investment strategist at Morgan Stanley, is fearful that companies that spin their results using pro forma figures could do serious damage to investor confidence in the financial markets. "Corporations have a lot of flexibility in how they report results," he said. "Nobody knows more about the truth than the corporate executives themselves. Taking a short-term view of truth may make things look good in a quarterly report. But it will ultimately catch up with them."

That is a good description of what seems to be happening today.

Beat Reporting 2002