Some companies just aren't ready for the Capital Asset Pricing Model. Most securities analysts are trained like short order cooks to examine a company's earnings stream, apply a multiple, get an answer, and get on to the next one. Value equals earnings times a P/E ratio. Certain ranges of earnings multiples and cash flow multiples are taught as being almost universal. Just like everyone likes bacon and eggs, everyone thinks six to eight times EBITDA is reasonable.

Fortunately, we now have a new crop of stocks that, despite their recent fall from grace in the market, persist in their challenge to many traditional notions of valuation. These so-called "New Economy" stocks, most of which are, in some way, related to information technology, have market capitalizations which fly in the face of traditional valuation measures. If a securities analyst looks at an "emerging-stage" company (that's one whose operations are being moved from a two-car garage to a three-car garage), has no earnings, and only has an idea which may be useful to a particular market segment within a couple or three years, an analyst is likely to assign only a speculative value to the enterprise.

This view, however, is contradicted by millions of professional and private investors who have poured billions of dollars into a group of information technology stocks which, while maybe not emerging stage, are certainly still development stage. The analyst who consults his or her valuation cookbook finds no help in justifying such lofty multiples. 1000 times revenues, 500 times book value, no multiple of earnings (no earnings), etc. But it would be wrong to simply dismiss the buying and selling of millions of investors with trillions of dollars of real money on the line. As the saying goes "money is smart", meaning that the investing public doesn't make a habit of supporting lofty valuations without a reason. Speaking more technically, we are reminded that the efficient market hypothesis generally purports that stocks are valued by the marketplace for a reason.

So, what does this mean to the valuation of new economy stocks? If a stock is valued as an earnings stream times a multiple, we must delve into the rationale for both to understand the valuation of a new economy stock. It may be not only that the multiples are skewed, but that the reported financial results prepared in accordance with Generally Accepted Accounting Principals (GAAP) are also skewed.

GAAP was not designed for the New Economy. Like Rene Magritte's painting CECI N'EST PAS UNE POMME (This is not an apple - i.e it's a picture of an apple), analysts have to cognizant of the fact that audited financial statements are a REPRESENTATION of a company's financial results, not the results themselves. The constructs of depreciation and amortization favor Old Economy stocks, allowing asset intensive businesses to write off the costs of bricks and mortar over their "useful lives."

A start up manufacturing concern can spend millions on highly specialized building and equipment. If they use straight-line depreciation and an average useful life of fifteen years, only about 6% of the cost of its capital investment is deducted from earnings each year as depreciation. This asset base is supposed to provide some comfort to investors in the event of a downturn in the business. But is that reasonable? If the manufacturing concern goes out of business, it's highly specialized equipment may have very little value in liquidation. And if the local economy is generally depressed, its real estate could have few buyers. Despite this, GAAP allows such a company to report a substantial asset base, and charge very little of it to quarterly and annual earnings.

New Economy stocks, on the other hand, tend to make their capital investment in systems, people, and brand-image. GAAP does not favor these sorts of investments. Although you might be able to capitalize some systems development (software and hardware infrastructure), the useful life over which it would be amortized would probably be short, say, five years, and thus 20% of the cost (on a straight line basis) would be deducted from earnings each year. Spending on people (compensation expense) and image building (advertising) cannot be capitalized, despite the fact that their value may extend well beyond one year.

If this sounds crazy, think about Coca-Cola. We don't have access to the early financial statements of the soft drink maker, but no doubt the market value of its stock was built on a very aggressive advertising campaign. Today, their operations consist primarily of advertising and carbonated sugar water. It still takes quite a lot of advertising to maintain and refine the image of Coke, but the impact is far less than if they were trying to establish a dominant global brand identity from scratch. Coca- Cola is not a New Economy stock, but the development of the small soft drink maker into a global brand followed the same pattern that Amazon.com or Yahoo have followed. Time will tell whether or not these New Economy stocks will have the lasting brand image of Coca-Cola; it is likely that most will not.

Now think about Ford Motor Company. Again, we don't have access to Ford's early financial statements, but the development years in which Ford was aggressively building factories to launch the Model-T were likely characterized by break-even or positive GAAP earnings, because those costs could be capitalized and depreciated over many years. Their cash earnings, however, were very likely negative in the early years. Yes, Ford did at least have assets to back up its value during the developmental stage. But what would an automotive factory have been worth ninety years ago if no one had wanted to buy cars?

FORTUNE MAGAZINE columnist Geoffrey Colvin has noted that that, if Amazon.com could capitalize its investment in intangibles, it would have reported a profit of over $400 million in 1999 (THE NET'S HIDDEN PROFITS; April 17, 2000), versus its reported GAAP losses of -$720 million. If one buys fully into Colvin's recasting of earnings, by my calculations, at its current pricing, this would result in a trailing P/E ratio of about 30x earnings (based on its recent trading price of $33 per share, it has an equity market capitalization of about $12 billion). Not cheap, but not ridiculous for a company whose revenues are expected to grow at supernormal rates for many years.

The valuation of New Economy stocks requires some thinking outside the traditional norms of financial analysis. This is healthy. At Mercer Capital, we are fortunate to have the opportunity to work with many New Economy companies that have challenged our perceptions of security analysis. And, of course, much of what we learn from emerging-stage information technology companies makes us better at understanding some of our favorite Old Economy clients, from ice cream producers to heavy equipment distributors.

We still think investors buy companies for their earning power, but it's important to not be too restrictive in what constitutes earning power, or what a rational expectation for earning power might be. Money is indeed smart, and we will continue to be open to learning from the wisdom of millions of investors, many of whom manage to consistently stay one step ahead of professional securities analysts.

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Mercer Capital provides business valuation, transaction advisory, and business sales & acquisitions services to clients throughout the nation. We conduct business nationally from our main office in Memphis, Tennessee and our Louisville, Kentucky office.

We provide a broad range of independent valuation and financial advisory services. Our services relate to gift and estate taxes, Employee Stock Ownership Plans, buy-sell agreements, fairness opinions, financial structuring of transactions and expert witness testimony. During 2000, we will provide services to approximately 500 clients located in more than 45 states and Canada. We have provided services to companies in more than 1,000 industry categories and identifiable sub-categories.

Through Mercer Capital Advisors, a division of Mercer Capital, we are also engaged on a regular basis to serve as transaction advisor to companies and financial institutions contemplating selling, acquiring, or undergoing some other form of corporate reorganization.

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