1. 

                       COMMENT & ANALYSIS: Stretching the figures: Calculating
                       accurate values for companies in the new economy takes 
more
                       than a grasp of mathematics - a dash of economics, 
politics and
                       logic would not go amiss, says John Kay:




                    COMMENT & ANALYSIS: Stretching the figures: Calculating 
accurate
                    values for companies in the new economy takes more than a 
grasp of
                    mathematics - a dash of economics, politics and logic 
would not go
                    amiss, says John Kay:
                    87% match; Financial Times ; 24-Apr-2000 12:00:00 am ; 
1170 words

                    Do the math. The slogan favoured by Jim Clark, creator of 
Silicon Graphics,
                    Net-scape and Healtheon, has become the mantra of a 
generation of
                    consultants and investment bankers. The new economy, they 
claim, requires
                    new principles of valuation. 

                    C.com is one of the most exciting prospects in 
business-to-business
                    commerce. It is the world leader in a growing market - 
annual sales by 2010
                    are likely to be Dollars 500,000bn. If C.com can maintain 
a 5 per cent share
                    and earn only 1 per cent net margin its prospective 
annual earnings will be
                    Dollars 250bn. 

                    If we assume that market growth after 2010 is 5 per cent 
and discount future
                    revenues at 10 per cent, the prospective value of C.com 
is Dollars 5,000bn -
                    about 10 times the recent market capitalisation of 
Microsoft, Cisco or General
                    Electric. 

                    You don't have to wait for the IPO. You can buy shares in 
C.com right now for
                    less than 5 per cent of that value. C.com is called 
Citigroup and in addition to
                    its foreign exchange trading, which is the business I 
have described, you get
                    its other wholesale, retail and investment banking 
activities and a leading
                    insurance company thrown in. 

                    Of course, nobody would be so stupid as to value 
Citigroup in this way. Yet I
                    have followed more or less exactly the methodology 
recommended in the
                    latest McKinsey quarterly for the valuation of new era 
companies. They use
                    precisely analogous calculations to arrive at a valuation 
of Dollars 37bn for
                    Amazon.com. 

                    Paul Gibbs, head of merger and acquisition research at 
J.P. Morgan, recently
                    used similar principles to confirm that assessment of 
Amazon. He then
                    performed the same calculation for internet service 
provider Freeserve. 

                    Assume that UK retail sales grow at 5 per cent a year, 
that 25 per cent of
                    sales take place on the net, that portals capture 50 per 
cent of these, that
                    Freeserve gets 30 per cent of the portal share and 
maintains an 8 per cent
                    commission on sales. Multiply these together and you 
establish that in 2017
                    Freeserve will make profits of o2bn (Dollars 3.2bn). 
This, he argues, justifies a
                    value today of o6.50 per share. 

                    But I prefer T.com to Freeserve. T.com has a customer 
base four times larger
                    than Freeserve. Its franchise is stronger. Its customers 
are concentrated in
                    the affluent south-east of England, where it faces 
virtually no competition.
                    Market research shows that more than 95 per cent of its 
customers use its
                    essential services every day, many of them several times 
a day. 

                    T.com also has ambitious plans for expansion. At present, 
its geographical
                    coverage is less than one-quarter of the market in 
England and Wales. T.com
                    has an interest in south-east Asia. The population of 
China is 100 times the
                    number of people who today can access T.com services. 
Even after the recent
                    market correction, T.com, better known as Thames Water, 
still has a market
                    valuation below that of Freeserve. At the widest point 
between the old and new
                    economies, Freeserve was worth four times as much. 

                    The reason the Citibank calculation is nonsense is 
simple, but fundamental.
                    The margins Citibank makes on its forex business vary 
widely. If you buy
                    small quantities of notes from a bank, the spread is much 
wider than 1 per
                    cent. If you are a large corporation trading major 
currencies, the margin is
                    wafer thin. Entry and competition force prices down to 
the related costs. 

                    In Mr Gibbs's model, Freeserve earns profits of o2bn, 
about equal to the
                    current profits of Tesco, J. Sainsbury and Marks and 
Spencer together. And it
                    earns these on revenues of only o2.5bn, so that profits 
are 80 per cent of the
                    value of its sales. No established business earns margins 
of that size. 

                    Thames Water is one of a tiny number of companies whose 
market position is
                    so strong, whose output is so necessary to life, that if 
it charged five times the
                    current price we would have little choice but to pay. We 
do have one option -
                    to insist the government intervenes. It confines Thames 
Water to a return on
                    its capital employed of about 6 per cent. 

                    The idea that profit is a return on capital invested 
still has some role in new
                    economy valuation, at the level of the overall market. 

                    There is a key formula in the new math. The required 
yield on a security is
                    equal to the difference between the rate of return 
demanded from that class of
                    securities and its expected rate of growth. So, if you 
expect a return of 5.5 per
                    cent from a share whose dividends will grow at 5 per 
cent, calculations show
                    that the dividend yield should be 0.5 per cent. 

                    This is the calculation done by James Glassman and Kevin 
Hassett in their
                    book Dow 36,000*. Claiming that sustainable dividends 
average half of
                    earnings, this yield equates to a price/earnings ratio of 
100 - implying a target
                    of 36,000 for the US index. 

                    The trouble with this theory is that it takes too long to 
produce what the
                    investor is looking for. Investors will receive only 
two-fifths of the cash
                    sustaining the valuation this century. One-third of the 
total depends on
                    dividend cheques that will arrive after 2200. 

                    Two hundred years ago, well before the Dow Jones average, 
prudent,
                    diversified investors would have owned slave traders and 
sugar plantations, or
                    perhaps a bold speculation in that symbol of the then new 
economy -a canal.
                    The next 200 years may be more stable than the last and 
Microsoft and Cisco
                    may prove more enduring than plantations. But we can 
hardly be sure. 

                    While 5 per cent may be a reasonable assumption for the 
growth rate of
                    dividends in the US economy as a whole, it is likely that 
well before 2200
                    most of these will come from companies not yet founded. 

                    Suppose we accept Glassman and Hassett's protests that 
their dividend
                    growth expectations are conservative. If you raise them 
only from 5 per cent to
                    5.25 per cent, the anticipated value of the Dow Jones 
average is 72,000. At
                    5.5 per cent the formula breaks down because the shares 
of US companies
                    are infinitely valuable. Not even the most credulous 
dotcom investor believes
                    that. 

                    The math also works in reverse. If expectations of return 
are 6 per cent rather
                    than 5.5 per cent, the market p/e ratio falls to 50 and 
the value of the Dow
                    Jones from 36,000 to 18,000. And if equity investors 
require a return of 8 per
                    cent, you would have to conclude that shares are worth 
only half their current
                    level. 

                    An 8 per cent expected total return is not ambitious for 
an equity investor. A
                    day trader might think you were talking about a weekly 
profit rather than
                    annual. Glassman and Hassett use a figure as low as 5.5 
per cent - the return
                    on Treasury bonds - because they argue that equities have 
so consistently
                    outperformed bonds that there is now no risk associated 
with equity
                    investment. In other words, because equities are sure to 
offer higher returns
                    than bonds, the expected yield on equities should be the 
same as on bonds. 

                    You do not have to be Wittgenstein to spot the flaw. The 
rules of logic hold
                    even in cyberspace, and so do the principles of 
economics. Profits are hard to
                    earn in competitive businesses, and markets that are not 
competitive are
                    usually regulated. The value of companies ultimately 
depends on their
                    capacity to generate cash for shareholders. Distant 
returns are uncertain.
                    Share prices are volatile, and investors need to be 
compensated for the risks.
                    These truths are as valid in the new economy as the old. 

                    By all means do the math. Isaac Newton, who could do the 
math better than
                    most, gave up an annuity of o650 per year to invest in 
the South Sea Bubble.
                    In addition to the math, you need the econ, the pol, and 
perhaps the
                    psychology. 

                    * Dow 36,000: The New Strategy for Profiting from the 
Coming Rise in the
                    Stock Market, James K. Glassman & Kevin A. Hassett, 
Random House,
                    1999. 

                    The author a director of London Economics. 

                    Copyright , The Financial Times Limited