Aside from the usual suspects–rising bond yields, “concerns about valuation,” nameless fear–Friday’s Nasdaq sell-off, which essentially cancelled out Thursday’s Nasdaq run-up, was driven by two analysts’ comments about Dell Computer. Dell has become one of the Nasdaq bellwethers, and so when analysts predicted that the company’s revenue growth for the just-ended quarter would fall short of estimates, panicky investors headed for the hills, prompting other panicky investors to do the same, and so on and so on.
Now, as it happens, the analysts’ predictions were dead-on. Dell reported its fourth-quarter earnings today after the bell, and although, in inimitable Dell fashion, the company saw its earnings-per-share soar 55 percent–in line with estimates, its revenues were $5.17 billion, which was short of the $5.5 billion that some had been expecting. That does mean that Dell’s sales still grew 38 percent from last year, a remarkable rate for an $18 billion company. But it was the first quarter in nine that Dell’s revenue growth didn’t top 50 percent, and on a sequential basis Dell’s sales growth has clearly been hurt by stiffer competition from the likes of Compaq.
If investors headed for the hills on Friday, then, they’ll be climbing the Alps on Wednesday to get away from Dell. After the earnings report, the stock plummeted 14 points, or 15 percent, in after-hours trading. This isn’t surprising, given how much weight people have been placing on this sales-growth number. But the Dell sell-off is a mistake, a mistake grounded in a fundamental misconception about how companies should be valued.
The conventional wisdom on Dell, after all, is somewhat schizophrenic. On the one hand, growth fund managers across the country own it, viewing it as one of those stocks that you just have to have in your portfolio (probably because it’s risen more than 3000 percent since 1995). On the other hand, these same managers, along with most of the financial press, talk about Dell’s sky-high price-to-earnings ratio and wonder whether even a company growing as fast as Dell should be valued this highly. In other words, everyone owns Dell but almost no one really believes that they should (a condition that may be characteristic of a lot of seemingly expensive tech stocks).
The problem here really rests in the sanctification of the price-to-earnings ratio as the key tool people use to evaluate how much a company is worth. In the old days, it was thought that a company’s P/E shouldn’t exceed its expected growth in earnings. Today, with so much more money in the market, that simple rule doesn’t really work, but “everyone” understands that a high P/E is a good sign that a stock is overvalued.
Unfortunately, “everyone” is wrong. To begin with, academic studies suggest that there is no correlation–positive or negative–between a company’s P/E ratio and the rate at which it grows in the future. In addition, “accounting earnings”–the earnings that a company reports–are complicated creatures, which often don’t provide any sense of the actual amount of cash that the company’s operations are throwing off (which is what would matter to you if you were actually running the business).
Finally, a simple focus on the P/E blinds investors to the most important number to consider in evaluating a company, namely its return on invested capital (ROIC). What you really want to know about a company, after all, is how efficiently it’s using its capital. You want a company to turn $1 in capital into $2 in cash, not $1 in capital into $1 in cash. And no company in America is better at doing the former than Dell. Its return on invested capital is historically above 200 percent, and has occasionally bettered that number. By getting money from customers before paying money out to suppliers, and by keeping inventories incredibly lean, Dell effectively lets its suppliers fund its operations. In effect, Dell is selling $18 billion of computers and servers a year while investing almost no money in the business.
The interesting thing is that although ROIC remains a relatively unknown concept in the world of investing (as opposed to the world of business), many of the stock market’s bellwethers–Dell, Microsoft, Coke, Cisco, Wal-Mart–have incredibly high returns on capital, as well as sky-high P/Es. In other words, investors appear to recognize that these companies deserve uniquely high valuations, even if most investors couldn’t exactly tell you why. That may seem like a crazy idea, but tomorrow’s Moneybox will try to explain why it’s not. How’s that for a cliffhanger?