Online Extra: Beware of High-Flying Tech Stocks

Yes, a few companies deserve their pricey valuations, but even those come with a dose of risk. Many others are just too dicey
The BusinessWeek 50

Tech stock prices, which plummeted after the stock market crash of 2000, have returned to lofty levels. Valuations haven't traveled quite as far into outer space as they did a few years ago, but many tech companies have achieved what might be known as high-earth orbit.

A quick glance at this year's BusinessWeek 50 shows that the firmament is bright with tech stars. Nearly one-third of the list comes from various parts of the tech universe, including software and hardware. That's a strong showing, because tech companies account for less than one-fifth of the S&P 500, from which the BusinessWeek 50 is drawn.

These tech stars can be pricey, too. The first, second, and third most-expensive companies, as measured by price-earnings ratio, are all tech companies. First is eBay (EBAY ), with a p-e of 75, more than three times the list average of 22. Apple (AAPL ) and Yahoo! (YHOO ) come in second and third with ratios of 72 and 56, respectively. That's a huge premium. The average p-e for the BusinessWeek 50 is 10.9, and the p-e for the Standard & Poor's 500-stock index, a standard benchmark for the broad market, is 7.5.


  Let the buyer beware. Some tech companies have legitimate reasons for commanding a premium. But overall, valuations are unsustainably high. Tech stocks, by their nature, invite speculative fervor, because the potential for success is unlimited. When Microsoft (MSFT ) (No. 41) hits it big, historic returns are possible. And when Apple (No. 14) produces a best-selling product like the iPod music player, investors often feel they can justify paying any price.

"By way of comparison, no one ever expects an energy company to report that it has discovered a vast new supply of oil, so investors don't place the same value on energy companies," says Brett Azuma, head of research at tech analyst RHK in South San Francisco, Calif. ConocoPhillips (COP ), ChevronTexaco (CVX ), and Valero Energy (VLO ), which rank second, third, and fourth, respectively, on this year's list, each have modest p-e ratios of about 10.

The problem is that the outsize rewards are enjoyed by only a few companies in the tech sector. For every Microsoft, eBay, or Apple, dozens of companies struggle to survive. According to analyst Bill Whyman of market researcher Precursor Group, tech revenue is expected to grow 8% to 10% this year, about twice the pace of gross domestic product growth. That's solid, but it doesn't support the sky-high valuations that are increasingly common in tech.


  The danger is that investors will start piling into risky second- and third-tier companies as leaders like Yahoo, eBay, and Apple become just too expensive for them. Does anyone really want to take a bet on investing in the next iPod?

Some analysts think investing in the original iPod is risky enough. "Apple is a provocative and interesting company, but it also carries extremely high risk," Whyman says. Apple's profit margin is a modest 5.2%. Yes, Jobs & Co. sell huge numbers of iPods. But with such low margins, it needs an extremely large revenue base to earn a profit. A decline in pricing or in the growth of sales would have a sharp immediate impact on Apple's financial health and stock price.

And there's always a risk that someone will develop a low-price digital music player that's competitive with Apple's groundbreaking design.


  Still, a few tech companies on this year's list appear to be reasonably valued. Wireless-technology pioneer Qualcomm (QCOM ) -- No. 13 -- has found a way to enjoy the benefits of the industry's growth while sidestepping its competition. How? It offers unique technology used by a slew of customers who compete with one another. Qualcomm has a reasonable p-e of 33 and healthy profit margin of 36%.

A similarly strong foundation may be supporting the success of computer giant Dell (DELL ). No. 15 on the list, Dell is a master of corporate process and operations, according to investment adviser Francis McInerney of North River Ventures. Dell's corporate machinery is so finely tuned, its inventory so tightly managed, that it can turn sales into cash faster than any of its rivals, McInerney says. That managerial expertise gives it a sustainable lead in the low-margin commodity business. And with a p-e of 34, it's not outrageously priced for a world-class competitor.

Even tech companies with reasonable p-e's can carry a lot of risk. That's especially true in the software sector. Microsoft and Symantec (SYMC ) have p-e ratios in the 20s, which is hardly high by today's standards. But the industry is becoming more and more competitive. Customers are buying lots of software from a few big players. That's turning software into an all or nothing game.


  Symantec's stock has been hammered lately because investors are nervous about its acquisition of Veritas (VRTS ) and about competition from Microsoft, which is putting more resources into competing in Symantec's security market.

If investors look carefully, they can still find some reasonably priced companies among tech's biggest names. But they need to remember that as valuations rise, so does the risk level.

By Steve Rosenbush in New York

Edited by Patricia O'Connell

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