Income Statements and Earnings - Which Way Do You Like It

[adios]

We've got GAAP earnings, EBITDA, EBIT, pro forma, S&P Core Earnings, S&P operating earnings, and IRS earnings if you will (what companies actually pay taxes on as generally speaking investors aren't privy to companies IRS filings). Did I miss any? I mean what does a PE ratio really mean. I understand that you have to look at a company on an individual basis but I think more than a few investors are confused. For instance the difference between S&P core earnings and S&P operating earnings on an aggregate basis for the S&P 500 is quite substantial. S&P core earnings include expensing for options for one thing but don't include goodwill impairment charges. I haven't done a full analysis of the differences. I guess that S&P 500 Operating Earnings don't include very many non-cash charges. That can be misleading too though. One reason I bring it up is that if we are discussing whether or not the market is overvalued as measured by historical PE's, we've got to decide what the "e" part is. I suppose the safest way to evaluate an income statement is to look at GAAP Income Statements and evaluate each line item. I'm fairly certain wildbill will disagree though as I vaguely remember him advocating the evaluation of cash flow statements as the best measure which implies in my mind using S&P operating earnings. One thing I've heard several times in the past month is that the non tech component of the S&P 500 has a much lower PE than the tech component. Probably a more accurate measure for many big cap tech companies would be enterprise value/core earnings ratios. I did a quick analysis of CSCO. Since I know exactly what S&P's criteria is for core earnings and operating earnings I used enterprise value/GAAP earnings and enterprise value/cash flow. For enterprise value/GAAP earnings was about 28.9 and the enterprise value/cash flow was 15. I believe that several Dow Components like Procter and Gamble have enterprise value/cash flow ratios of around 14 but I haven't checked recently. So CSCO perhaps is in the ballpark as far as a fair valuation. Not sure what the conclusion is other than the big caps to me don't seem extremely unvervalued and perhaps a little over valued.

One other note. The S&P has more or less rallied from the 800 level a couple of times in the past 6 months or so. That puts the market back to levels of April of 1997. If the bears are right and the market ultimately makes a low for the current bear cycle in the 650 area (I've heard even lower) that's the levels seen in April of 1996. Which would mean the market went sideways ultimately for 7 years. Now some super bears say that market history shows that we have to go much lower than S&P 500 of 650 to reach a true bottom. In April of 1995 the S&P 500 was at 500. In April of 1994 the S&P 500 was at 445 and in April of 1993 it was at 451. So if the market loses about 50% from here we've gone sideways for 10 years instead of 5.

[Mark Heide]

Tom,

According to my basic analysis CSCO is overvalued if you just look at P/Es for an indicator. Its current P/E is 36, but for me to consider even owning it, CSCO would have to go below $13. I have a few economic and other reasons. First, is the media is still in love with this company. Secondly, average investor is still in love with technology. Thirdly, information technology sector is still terminating employees. Fourth, the unemployment claims went up to 6% nationally, with 7% or more for California, Oregon, and Washington (these are the states were all these types of technology companies are based). Router and switch technology relies on capital spending to increase for growth, so I don't think you will see that now. There are companies buying these products but not at the rate they were prior to the internet expansion. Lastly, since this is a company that does not pay a dividend, I think you have to sell these types of investments when they are overvalued and people are in love with them for the wrong reasons. The only time I saw CSCO come close to its real value was last summer.

So, I guess what I am saying is besides earnings, it's important to determine what type of future these types of companies will have.

Good Luck

Mark

[adios]

Actually I agree with you on every point. I would go a little further and state that IT products are under a lot of pricing pressure as well. Great for the IT consummer bad for the companies making the products. Some investors are claiming that if you take the technology component out of the S&P 500 then the market is reasonably valued on PE basis. But which E do you use? I believe most of these folks are basing it off of operating earnings. Wildbill may come along and say that investors focus too much on ther earnings statement and that's a valid point too. But if we're using historical benchmarks to value the overall market, I'd like to use the most relevant one. I mean the investors that say it's fairly valued without the tech components may be right and what you stated about tech stocks would bare this out.

[Wildbill]

Don't get ahead of yourself is what I would say. One thing that analysts say that I actually agree with is that almost every subset in the market has its own "best" metric. The types of earnings or even non-earnings number such as EBITDA should only be used when comparing like companies. Don't try to make one number fit for all companies in all types of industry because the idea just isn't going to work well.

You are missing the basic reason why tech will almost always have higher P/E ratios. Tech companies are almost all high-margin businesses because of the very nature of most of their products. Flextronics and other manufacturing heavy companies sometimes get thrown in, but the average tech company is one that uses its R&D and creates products with knock your socks off margins. Right now with no one buying its obviously not a great proposition, but the basic thing to remember is if Ford increased their sales by 10% and an average tech did the same, the tech company would clobber Ford in terms of improvement in bottom line numbers. I think this is something a lot of people are missing right now. Doesn't look so great to be a tech company, but all they need is a little momentum and a good new generation product and their ratios suddenly can change. Of course people pile onto them and keep the ratio high, but if you were to buy a tech right now and it does well in a year you got in when the sweet spot was hit. Further those unemployment numbers are good from my thinking, that great talent is available and you don't have to pay ridiculous salaries to get it. People will raise a fit sometimes, but right now is the best time to give out options, not when everything is great with the market and the company. Frankly most companies out there would love to have the problem of dilution from options as long as they don't overdo it. I am still on the fence with what exact metric to use in most industries, but I just will say that you need to pick a couple and do your comparison there.

[adios]

A few general comments. I agree with you totally about like comparing companies earnings and "one size does not fit all." The problem with tech is more or less what scalf alluded too. There isn't enough innovative new products to drive revenue and earnings growth. There are certain areas where margins are great and companies in those areas are making lots of money such LLTC but of course the market recognizes these companies already. I will admit that many tech companies are now "lean and mean" and incremental increases in revenues would mean a lot to the bottom line. However, there is at least a fair amount of margin compression occurring in various sectors of tech land so we'll probably have to agree to disagree on the prospects for big cap tech.

[Mark Heide]

Tom,

I pretty much agree with you and Wildbill.

Wildbill's reference to Ford works the same with a lot of technology companies too. Since, Ford does spend on R&D to improve its product line and gererate new models.

Technology companies fall into the same trap if they are hardware based like PCs, Routers, Switches, Hubs, etc. Or they are only successful at a one line type of product like Novell was for their operating system for LANs. I remember back in the early 90's the Novell stock was high priced and LAN was the buzz. They were unsuccessful at maintaining their market share after a few years with competition from Microsoft and their stock dropped below $10 a share. The econmic situation forced them to layoff and scale down, just like today the buzz is INTERNET with the same things happening.

Basically the tech companies either hit a peak and then decline into oblivion, or they diversify (like IBM), or get acquired. When companies sell like products, it takes more than having a good product to survive. This is why I think CSCO had survived and will probably be around a long time, but can you really make a long term profit owning them? I believe that CSCO success so far is due to a very aggressive sales team and good management.

Basically, I'll go along with Warren Buffett and stay away from technology, unless I can forcast their future.

Mark