Market Watch: Think government IT stocks are overvalued? Think again

Jerry Grossman

The Federal Reserve's recent reduction of the short-term interest rate to 1 percent reflects a continuing sluggishness in the U.S. economy overall. Many investors are assessing what these very low borrowing costs mean for both the economy and their investment portfolios.

Government IT markets, contrary to most of the economy, are growing at a faster pace than the pre-2001 period. Considering these trends, how should the industry be valued?

A close look at historical pricing, present circumstances and traditional investment theory would suggest that price-to-earnings multiples, or PEs, of government IT companies should be above their recent historical norms. Here's why this may make sense.

A company's price-to-earnings ratio, a traditional valuation metric in the public market, is its price per share divided by earnings per share (EPS). In theory, a company 's PE ratio is a function of three principal factors: next year's projected EPS for the company, its long-term earnings growth rate, and investor's required rate of return on equity.

Higher PE ratios should result from higher EPS in the year ahead, a lower required rate of return on equity or a higher long-term growth rate. For this analysis, we examined the trends over the past 10 years in each of these factors for government IT companies.

The results: Projected 2004 earnings growth and expected longer- term growth for the public government IT peer group are higher relative to the 10-year period. For many companies, these growth rates have increased by 10 percent to 15 percent or more.

As for the rate of return required by investors, which directly affects their pricing of stocks, the most comprehensive and frequently cited source of equity return data is published by Ibbotson Associates. The annually achieved rates of return for public market equity investments are summarized by company market capitalization and compared to the risk-free rates of return, represented by Treasury bonds and bills.

The difference between the total equity returns achieved in the capital markets and the risk-free rate is referred to as the equity risk premium. An examination of these equity returns over the past four years reveals that investors' required equity return rates have declined by 15 percent to 20 percent. This decline has resulted from a 1.5 percent drop in Treasury rates, combined with an approximate 1 percent fall in the equity risk premium.

The impact of the lower required rate of return, all other factors equal, would be an increase of 25 percent or more in the industry PE ratio. Increased growth rates of 10 percent, all other factors equal, would imply a PE ratio increase of another 20 percent or more.

The government IT industry PE ratio, calculated on trailing 12-month earnings, is about 24. The 10-year average and median PE ratios for this group are about 22, an increase of only about 9 percent.

Accordingly, some investors might argue that current valuations, and the PE ratios which these prices imply, do not fully reflect the industry growth outlook, investment risk profile, or current required return levels for public market investors. You are welcome to form your own conclusions. *

Jerry Grossman is managing director at Houlihan Lokey Howard & Zukin in McLean, Va. He can be reached at jgrossman@hlhz.com.

About the Author

Jerry Grossman is managing director at Houlihan Lokey Howard and Zukin.

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