Manager's Journal
Stocks Overvalued?
Not in the New Economy.

By LOWELL L. BRYAN

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.

'Irrational Exuberance'?

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 bonds.

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 capital.

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 equity.

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.

Valuing Options

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 options.

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.

Mr. Bryan is a partner in McKinsey's New York office.