If Capitalism is the Engine, who's Driving?
If Capitalism is the Engine, who's Driving? PART I: Stock market valuation
A recent Tim O'Reilly post pointed out that United Technologies saved 1% by transferring 1400 jobs to Mexican workers. His article focused on the demands that shareholders are making for United Technologies to dramatically lift earnings by 17%. In an economy where interest rates are hovering around zero, such demands are a prescription for long term disaster for any company that needs to squeeze money out rather than investing for the future.
How companies are valued is not a trivial question: it drives decisions that move trillions of dollars, picking winners and losers while determining public policy in many areas. In this series, we look at some of the ways that companies seem to be valued in the current economy, as well as newer models being used by major investment advisors.To start, we look at a few public metrics in a range in companies, especially contrasting Facebook and United Technologies.
The price of the current stock times the number of shares outstanding is the Market Capitalization (market cap), a broad brush that shows the weight of the stock in the eyes of investors. United Technologies market cap is $82 Billion compared to Facebook’s $324 Billion. The question arises, what is it about the company that makes investors place such a high value on Facebook’s shares?
This isn’t a rant against Facebook: it is a wonderful way to keep in touch with an extended family. Many companies use their Facebook site to keep in touch with changing consumer demographics and to get early alerts on product successes and failures. But investors should need a rationale for investing in a company with a market cap that is larger than that of Tesla, Dow, United Technologies and Cisco.
It isn’t revenue.
United Technologies revenue is at $56 billion, compared to Facebook’s $17 billion. Dividing the market cap by the revenue gives a multiple of revenue needed to match the market cap. Facebook is currently selling at a multiple of 19, while United Technologies is 1.46. Although Facebook's advertising revenue is rising, they have a long way to go. Conversely, United Technologies could be seen as undervalued, given the size of their revenue compared to market cap.
This is supported by another metric, Price/Earnings Ratio (P/E), which is the price of the stock divided by the earnings per share. Facebook is at 87.6 vs. United Technology’s 22. What that means is that an investor will pay $22 for each dollar of United Technology’s earnings or $87.6 dollars for every one dollar of Facebook’s earnings.
[*Tesla, as of this writing, had a negative P/E ratio. However, the company has now pre-sold 217,000 Tesla Model 3 cars at a price of $1,000 each, netting a two year, no interest loan of $217,000,000. A new model for company valuation, Tesla could be a harbinger of more to come.]
Perhaps Facebook 'feels' familiar: it is a technology easily understood and used by millions. What a company like United Technologies does, and how their products contribute to our daily lives, is much less accessible. Yet Facebook's Market cap is substantially larger than Amazon's, a company that has surely been a part of as many lives as Facebook. Amazon's revenue is close to GE, and they employ thousands. Their local distribution centers have benefited many troubled communities. So it isn’t the number of employees.
There are two ways to look at employment:
- higher employment means a more productive society
- lower employment at the same revenue level means a more efficient one.
If a goal is of our economy is to ensure there are enough jobs for our present and growing population, United Technologies is the big winner at 197,000 vs Facebook’s 12,691.
However, if efficiency is the goal, then dividing revenue by the number of employees provides a theoretical amount of productivity produced by each employee. In that case, Facebook’s 12,691 employees are responsible on average for $ 1,339,532. This discrepancy may be part of Facebook’s charm for investors. While it would take a growth of 19 times current revenue to come close to Facebook’s current market cap, an addition of a few employees could make the stock skyrocket if each employee did indeed bring in an additional $1.3 million. That kind of logic, however, leads us to another way to market valuation: magical thinking.million in revenue, compared to United Technologies $284,000 per employee.
My first experience with magical thinking came when I was working in Silicon Valley in the mid to late 90's. Those of us – non-players drinking martini's while discussing market trends over crispy artichoke hearts in trendy South of Market restaurants – knew it was a bubble. How, then, could those much smarter than us be investing? What was the appeal of what we called the 'PockaDotBowTies.com': companies getting millions from Sand Hill venture capitalists (VCs)? These startups were paying our six figure salaries, relying on various rounds of funding but rarely with anything close to a revenue model.
Where was the money coming from? One theory was that money came from baby-boom liquidity -- real or imagined funds saved over a long working lifetime. The real was funds in various investment vehicles and banks; the less real those funds leveraged to buy more stock or mortgages on homes that would 'inevitably' rise. So that was where the money could be coming from.
What, in turn, were the VCs thinking? One part of the Silicon Valley bubble was that ten or twelve companies soaking up a few million each was okay if only one netted hundreds of millions or even billions in an IPO. Excited by early successes, a new generation of VCs entered the market, creating funds by investing in companies they didn’t really understand, selling into markets that they couldn't possibly predict. The result was the bust of 2000, in which many companies closed, people lost jobs and those who invested paid a heavy price.
Such booms are not new news. The Depression catered to savings – leveraged beyond sustainability -- from a rising middle class excited by the winners in the new technologies:mass production, automobiles and oil. The Savings & Loan was fueled by small banks, with no real expertise in markets or the economy, suddenly being allowed to invest portfolios of their client’s savings.The difference in the dot.com bubble was that it – by its very nature – fueled a huge change in the information available to investors, through the amassing of publicly available data that could be analyzed by sophisticated mathematical models.
The ability of computers to accumulate huge data sets created a new breed of investors who only look at numbers through the lens of terms like Stochastic Oscillator, Chi Square Statistic and Balanced ANOVA. Less advanced markets were similarly fueled by numbers that, in some cases, were pure fiction. Bernie Madoff’s success was based on his investors’—and governing agencies’—willingness to accept data that looked right, without investigating the underlying assets. The ‘Big Short’ was an opposite example: the underlying value showed huge gaps that lead to a bet against the prevailing market wisdom that, in the end, proved right.
The idea that it is possible to get very rich by depending on mathematical models can be a dangerous model. The converse, looking at the real value of what companies do and how they do it has been hard work. However, investment managers are using new metrics to value stocks. Metrics that provide transparent access to data on company competitiveness, innovation and longevity.
What is changing is that major investors, the institutional investors with billions to protect, are thinking of new ways to value a company. Those new ways involve metrics that are being lauded by activist investors and large, conservative advisory firms.
Next: Part II - Valuing corporate innovation and competitiveness.