Investing: Stocks Overvalued?

Mark Crosby (
Fri, 7 Nov 1997 11:14:15 -0800 (PST)

The following is from an article in Monday's WSJ by
LL Bryan called "Stocks Overvalued? Not in the New

Are stocks fundamentally overvalued? Is last week's
turmoil the beginning of a sustained bear market, as
stocks return to "normal" valuations? Almost
certainly not. The world's equity markets have been
driven to today's levels for good reasons: The cost
of equity capital has declined, and the value of
intangible capital assets has increased dramatically.

There's no question that the world's stocks are
priced differently than they were at the start of the
1990s. Market-to-book ratios of U.S. companies are
now about 2-to-1, roughly double the average between
1945 and 1990. Price/earnings ratios in the U.S. are
at 25, vs. a historic average of about 17. My
colleagues at McKinsey and I analyzed the performance
of the 100 largest companies world-wide and divided
them into groups based on their earnings growth and
returns on book equity since 1991. We then took the
20 of these companies with the least change in
absolute performance. These 20 companies had an
average increase in earnings of 3.8% compounded
(little more than inflation) while return on book
equity was flat (9.9% in 1991 and 1996). Yet their
market capitalization grew by 13.5% compounded.

Since the performance of these companies was
unchanged, what must have changed was the price at
which the market valued that performance. Many
attribute this change to "irrational exuberance." But
our research indicates that the underlying cause is
that the cost of equity capital is falling. Research
by McKinsey two years ago estimated that there will
be a $12 trillion increase in household financial
assets by 2002 due to the aging of the developed
world's population. The research also found that the
demographic forces driving this extraordinary demand
for financial assets will continue to increase
through at least 2010. Many of these household
savers, especially in the U.S., have begun to develop
a clear preference for equities over bank deposits or

At the same time, corporate investment in tangible
capital stock is declining. The ratio of revenue to
the sum of property, plant, equipment and inventory
for U.S. companies has increased by some 20% over the
past 25 years. This means that U.S. companies are
using about $530 billion less financial capital than
they would have used otherwise. As companies
elsewhere follow the U.S. lead in improving
productivity, they too will release significant

Meanwhile, governments in the developed world have
dramatically slowed down the pace of new debt
issuance; their bonds thus will absorb less household
savings. In the past two years, we have reduced our
estimate of the amount of government debt that will
be outstanding in 2000 by $4 trillion. Our research
also indicates it will be a decade or more before
emerging markets will have a significant impact on
world-wide supply and demand for capital. It
therefore appears that there will be plenty of liquid
financial capital seeking equity returns at least
through the next decade. And whereas market breaks
quickly eliminate speculative demand, it would take
massive changes in investor demand, or massive new
debt issuance by governments, to increase the cost of

Also driving the market up is the strong performance
of companies pursuing global opportunities. To
understand this effect we took a different list of
100 global companies--those with the greatest
increase in market capitalization since 1992. These
companies grew their market cap by 24% compounded and
produced returns to shareholders of 30% compounded
over the past five years. Overall, their market
capitalizations increased from $1.6 trillion to $4.7
trillion, of which $2.7 trillion represents an
increase in market value over book. That is, their
market-to-book ratios doubled, to 4.2 from 2.1.

Outstanding stock market performance for this group
is not surprising given that their earnings increased
at 23% compounded and their return on book equity
increased from 9% to 17%. But is a market-to-book
ratio of 4.2 reasonable?

It could well be. Consider that historic accounting
conventions understate both earnings and book capital
when companies spend on "intangibles"--people,
patents, brands, software, customer bases and so
forth--which are increasingly the sources of value in
today's global economy. Money that companies spend to
create these intangible assets is considered an
"expense" rather than a capital investment. For
example, a rough estimate of the costs of the
installed base of software in the U.S. is over $1
trillion, but most of this investment has been
"expensed" even though as a by-product of this
spending, intangible assets are being created that
have value that will endure for years.

The inadequacy of our accounting conventions is not
new. What is new is that the forces driving us toward
a global economy--deregulation, lower transaction
costs, more liquid capital markets--have made the
potential value of intangible assets much higher.
What's also new is that companies are investing in
these intangible assets more strategically and
consciously. Commercial life insurers, for example,
are building cross-border expansion plans around
their ability to understand risk rather than
nondistinctive portfolio balancing and selling skills.

Investors know this--but we have no accounting
methodology for recognizing the value of investments
in intangible assets. As companies accelerate
spending on intangibles to capture global
opportunities, "earnings" are being understated while
returns on book equity and market-to-book and
price/earnings ratios are being overstated. In other
words, current stock market valuations are more
reasonable than they appear.

As companies are learning how to use their intangible
assets by moving them around the world--through
licensing agreements, alliances and other
strategies--they are also learning how to create and
hold options--making investments in brands,
technologies, local market knowledge and so forth in
order to stake claims on future global opportunities.
Increasingly, investors are placing value on these

Thus, we believe that many companies with high market
capitalizations have real option value built into
their stock price. When a company is a standalone,
this option value is transparent. The Internet search
company Yahoo! has a market capitalization of $1.4
billion on annualized revenues of about $70 million
and a book value of $110 million--clearly a
reflection of its option value. Less obviously,
companies like General Electric, Smith Kline Beecham,
Intel and Citibank have real global option values
built into their market capitalizations.

These developments have outstripped the financial
accounting conventions, the capital budgeting
methodologies and even the mental models most firms
use to run themselves. Investors hoping for the
market to fall to levels that feel more "normal" are
likely to have a very long wait.

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