IPOs, Earnings and Stock Prices
By: William C. Herber, Joseph B. LaPray and Robert J. Strachota
A 77% return on investment in one day? That is the capital gain an investor in Pixar Animation Studios would have made by buying the stock at its initial public offering price of $22 per share on November 29, 1995 and selling it at the closing price of $39 on the same day. Pixar is the company which created the computer animation for the Disney movie Toy Story.
While PixarPEs initial public offering (IPO) performance may seem remarkable, it is not unique in todayPEs market climate. Since 1990, approximately 2,800 companies have had IPOs, raising some $130 billion, $29 billion of this in 1995 alone. Most of these IPOs were not greeted with the same frenzied acceptance that Pixar enjoyed, but a few, such as Netscape, Secure Computing and others, have seen their stock prices rise 100% or more from their initial offering price within days or weeks of first hitting the market.
Generally, the value of a stock is whatever someone is willing to pay for it. The value depends on the buyerPEs hopes of future benefits to be generated by ownership of the asset. One way to determine if investors have high hopes for the future returns a company will provide is by the price to earnings ratio (PE ratio) of the companyPEs stock. The PE ratio is calculated by taking a stockPEs price per share and dividing it by the companyPEs earnings per share (which is found by dividing a companyPEs most recent annual profit by the number of shares outstanding). This simple PE ratio calculation provides a number by which to evaluate the relationship between a stockPEs price and its earnings per share.
A PE ratio of 20 means that investors are willing to pay $20 for every $1 of a companyPEs earnings. The only reason that someone would trade $20 for $1 is because the investor hopes there are a lot more dollars where the first one came from, and they want to be in line to collect them. A high PE ratio generally means investors think the company has good growth potential (will provide high future returns) or that the companyPEs earnings are relatively safe from future decline (have little risk).
The average PE ratio for the Dow Jones Industrials over the years 1920 to 1994 was 12.8, and as of February 8, 1996 their average PE was 15.7. This means that historically, investors have been willing to pay on average $12.80 for every $1 in annual earnings (for Dow Jones Industrial stocks), but today they are willing to pay $15.70 for that dollar of earnings, indicating that in general, investors believe that future earnings will justify their expensive (by historical standards) investment. By this measure, investors appear more hopeful today than they have been on average over the period from 1920 to 1994.
The relationship between stock prices, profits and investorsPE hopes can be seen in the saga of Cray Research. In 1983, investors had high hopes for Cray Research, a fast growing young "high tech" company which dominated its market and had an average PE ratio that year of 25.8 (much higher than the 1988 PE for the Dow Jones Industrial Average of 14). Investors were willing to pay $25.80 for each dollar of CrayPEs earnings because they thought CrayPEs future earnings would justify the investment. In this case, investorsPE hopes were rewarded, because in 1983, when CrayPEs PE ratio was 25.8, the companyPEs per share earnings were only $0.89, but by 1988 the companyPEs per share earnings had risen to $4.99, a compound annual growth rate of 41.17%. Over the same period, CrayPEs stock price went from the $20 to $30 per share range in 1983 to an all time high of $135.80 before the market crash of 1987, and then recovered to a high of $88.50 per share in 1988 (with prices adjusted for a 2 for 1 split in 1985).
While CrayPEs earnings and stock price were rising in the middle 1980s, the stockPEs PE ratio dropped, going from 25.8 in 1983 to 14.9 in 1988. Put simply, although CrayPEs stock price and earnings both rose handsomely between 1983 and 1988, its earnings rose proportionately faster, and the PE ratio fell because CrayPEs earnings caught up to its stock price. By 1988, investors were no longer willing to pay $25.80 for each dollar of CrayPEs earnings because there was not the same attractive earnings growth potential for the company in 1988 that there had been in 1983. However, even at the lower PE ratio of 1988, CrayPEs investors had still overestimated the companyPEs potential. While CrayPEs 1988 share price peaked at $88.50, with a corresponding average PE ratio of 14.9, the 1988 average PE ratio for the Dow Jones Industrials was only 9, indicating that investors thought that the future of their Cray investments was brighter than that of the other Dow Jones Industrials.
Unfortunately, CrayPEs earnings never again reached their 1988 peak, and by 1995 the company had become unprofitable. In early 1996, when CrayPEs stock price had fallen to the neighborhood of $25 per share (approximately 72% below its high for 1988), the company was taken over by Silicon Graphics. Those investors who were optimistic enough about Cray in 1988 to pay 14.9 times earnings for the stock (when the PE ratio for the much safer Dow Jones Industrial averages was only 9), and had held onto it until 1996, paid a high price for their optimism.
Nowhere in the current stock market is investor optimism more apparent than in the market for IPOs, particularly those of companies that can somehow be categorized as "high-tech." Pixar is an excellent example of this investor optimism because its IPO success came in spite of the fact the company had lost money in each of the last five years. An investor in Pixar would have to hope that the company would someday, somehow, find a way to create real wealth, in addition to cartoons. If investors would pay $39 per share for Pixar, which had nonexistent earnings, what would they pay for real earnings?
GT Interactive Software was a December 1995 IPO with a track record of real earnings. As noted in the Market Transaction section of Valuation Viewpoint, GT Interactive Software (GTIS) had pro forma 1994 earnings of $16,629,000 and had its IPO on December 14, 1995. Based on the 59,296,424 shares outstanding after the IPO, the price to earnings ratio for GTIS stock was approximately 49.92. At a price of $14 per share, the companyPEs earnings per share would have to increase 390% to bring the stockPEs PE multiple in line with the average PE multiple of the Dow Jones Industrials over the 1920 to 1994 period and approximately 320% to match the current PE for the Dow Jones Industrials.
Predicting earnings for a company with such a short history is risky, as can be seen in the price volatility of GTISPE stock. Although GTIS stock has traded as high as $16.50 per share (in the first few opening days only), it has also traded as low as $8.86 per share, and as of February 21, was back to its original IPO price of $14. The message sent by the marketplace is that it is uncertain what GTISPE future earnings will be.
Investors in companies such as Pixar and GTIS are buying the stock in the hope that either: (a) the companyPEs future earnings will increase dramatically and justify the price they have paid, or (b) they will be able to find another buyer for the stock who will have even greater hopes for the companyPEs earnings potential and be willing to pay more for the stock. The fact remains that at some point, the companyPEs earnings performance will have to justify the hope of investors, or the price per share will fall. In view of the prices paid for Pixar, GTIS and other recent "high tech" IPOs, any earnings growth short of spectacular will be disappointing.
As demonstrated by Cray Research, a stock with a higher than normal PE ratio cannot be expected to maintain that ratio forever. High PE ratios are not sustainable because either investorsPE high expectations will not be met and the stock price will fall, or earnings will rise to meet expectations as the companyPEs growth potential is realized. The perception of high potential earnings drives PE ratios upward, but investors with unrealistic expectations of earnings growth will be doomed to a life of disappointment if they expect a stock to permanently sustain a PE ratio above market norms. Investors who buy stock with PE ratios above the marketPEs normal range are buying into hope, conjecture or emotion, not tangible results. While in the short-term, a stockPEs price may be driven by optimism, and while a companyPEs earnings performance sometimes justifies investorsPE hopes, in the long run, it is performance that counts. 
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