Commentary: How Do You Read This Crazy Market?

Warning: You are entering the fifth dimension. A dimension in which the Dow Jones industrial average has five digits, a new Internet bottle rocket goes public every five days, and at least five people you know are day-trading stocks from home in their underwear.

Still, the craziness surrounding this bull market doesn't necessarily mean stocks are overvalued. Some people even think they're undervalued. Bar furniture has been destroyed in arguments over this very issue. In fact, that's the point: The market is harder to predict than ever, and the old measuring rods come up short. Investing in stocks today demands a high tolerance for uncertainty.

Blame the high-tech, high-growth, high-volatility New Economy for complicating things. The stock market is dominated increasingly by companies that either produce technology or use it intensively. Technology may have grown more familiar to us, but its effect on corporate and economic performance is still unpredictable. "It's just a huge, gray, amorphous, fuzzy area," says Martha Amram, co-author with Nalin Kulatilaka of a new book, Real Options: Managing Strategic Investment in an Uncertain World. Amram and Kulatilaka calculate that the volatility of 30 New Economy stocks they track--including America Online, Microsoft, and Intel--is about 50% higher, on average, than that of Dow stocks.

Of course, the compensation for volatility is the promise of superior growth. That's obvious with highfliers such as Yahoo!, but it is increasingly true for a broad range of companies. What is driving the Standard & Poor's 500-stock index to new highs and historically high price-earning ratios? PaineWebber Inc. notes that in 1978, energy was the s&p's biggest sector, with an 18% weighting. Now it's 6%. Technology's share is 19%, up from 12%.

It's far too soon to start applying the emerging valuation rules for New Economy stocks to every company, of course. The time-honored tool, discounted-cash-flow analysis, works fine for valuing such companies as Coca-Cola or General Motors that are in fairly predictable businesses. That method values a company by calculating the current value of future income and expenses.

But the conventional measure doesn't do much good for many New Economy companies because their profits are so far in the future and so uncertain that their discounted value becomes meaningless. Better to start by thinking of such companies as a portfolio of opportunities. It's useful to understand how this approach works because more and more companies are embracing high-risk and high-reward strategies.

VALUABLE OPTIONS. Consider beat-up Advanced Micro Devices Inc. The chipmaker's survival depends on flexibility--choosing the right options--because it lacks the reliable cash flow of its nemesis, Intel Corp. amd has lost money the past three years. But it is smack in the middle of a red-hot industry that constantly generates new business opportunities. Even if most don't pan out, one or two of those options could turn into blockbusters. At the moment, amd is making inroads in the sub-$1,000 PC market, where margins are continually under pressure. A conventional accounting approach might tell amd to close shop or scale back sharply. That would be a huge mistake because amd has valuable options--if it can choose wisely.

There's a lesson here for investors in all segments of the stock market. Increasingly, it's important to look not just at discounted-cash-flow models but also at a company's portfolio of opportunities. Pick managers who know how to ditch bad ideas quickly and seize on new ones. Says Larry G. Chorn, visiting professor of finance at Thunderbird, the American Graduate School of International Management in Glendale, Ariz.: "This really places a value on management's ability to extract value in midstream as more information becomes valuable."

Sorry if this sounds fuzzier than what they teach in business school. But in valuing New Economy stocks, which account for an ever growing share of the overall market, it's better to be approximately right than exactly wrong.

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