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Personal Finance > Ask the Expert  
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Techs: Low enough to buy?
With tech stocks so low, is there any real risk in the industry leaders?
April 22, 2002: 3:37 PM EDT
By Walter Updegrave, CNN/Money Contributing Columnist

NEW YORK (CNN/Money) - With tech stocks so low, is there any real risk in investing in industry leaders? Take Sun Microsystems. It traded in the $50's in 2000 and has recently been trading between $8 and $10. I know it won't reach $50 again soon but it can easily be at $20 or so within a year or two with some consistent earnings. What's stopping me from doubling down and cashing in?

-- Paul Singh, Stockton, Calif.

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I'm in awe of your optimism, but I'm not quite sure what you base it on. I mean, back in 2000 before the tech bubble deflated and major tech firms were selling at what we now know were irrationally exuberant prices, analysts and investors were still predicting huge upside potential for these stocks.

Turns out they were way off (or way early, if you want to be charitable). So I don't understand why your expectations of a quick doubling in price over the next one to two years are any more realistic than theirs were. What, you think that it's no big feat for a stock selling at $10 a share to get back to $20 because it's already sold at a much higher price?

The past is not the future

I'm going to let you in on a little secret: a stock's past price has nothing to do with its future price. That's true not just for Sun Microsystems, but for any stock. For the most part, what determines a stock's price are its expected earnings per share and what people are willing to pay for those earnings per share. That willingness is expressed in the price-earnings ratio. If a stock has a high P/E, it shows investors are willing to pay more for those earnings than for a stock with a lower P/E. So the only two things that are going to raise a stock's price are an increase in earnings and/or an increase in its P/E ratio.

Now, I'm no stock analyst (thank god), so I'm not going to claim I have any particular insight into Sun Microsystems' earnings (except to note that just last week it reported a fiscal third-quarter loss of $37 million, or 1 cent per share).

But if you go to the analysts' earnings estimates for Sun that are available on CNN/Money.com, you'll see that the average estimate for Sun's next fiscal year's earnings (June 2003) is 19 cents per share. I have no idea whether they'll make that target -- there's also a "high" estimate of 35 cents and a "low" estimate of 4 cents -- but let's assume for the moment that the stock is trading on the basis of that average estimate. Given its recent price of $8.50 a share, Sun has a P/E ratio of 45, which means investors are willing to pay 45 times the 2003 earnings estimate for a share of Sun stock.

Now, what would have to happen for the stock price to double within two years? Well, if earnings estimates doubled over the next two years, that could do it. For example, if earnings grew to 38 cents a share and the stock continued to trade at its P/E of 45, Sun would trade at roughly $17.

Similarly, a higher P/E ratio (what's known as "multiple expansion" in the trade) could also boost the stock price. Let's say that earnings remain the same at 19 cents but, for whatever reason, investors become much more ebullient about Sun's future prospects and were willing to pay 90 times earnings for a share. With a P/E of 90 and earnings of 19 cents, the stock would also sell for $17.

Or, you could have a combination of an earnings increase and a higher P/E. For example, if earnings climbed to 25 cents a share and investor optimism pushed the P/E to 57, then Sun shares would sell for $17.

Keep an eye on reality

Are any of these scenarios -- or some permutation of them -- likely to pan out? I have no idea. But if you think Sun's share price can "easily" double within a year or two, then you had better have some good insights into why one of these scenarios is likely to unfold.

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I will say this, though. I don't see a doubling in price as a baked-in-the-cake, lead-pipe-cinch can't-miss choose-your-own-cliché given. We're talking about significant earnings increases and/or substantial multiple expansion here. True, things could work out even better. But there's always the risk that earnings might fall short and investors might decide to pay less rather than more for those earnings. (Hey, didn't that happen recently?)

Keep in mind that my aim here isn't to evaluate the prospects for Sun Microsystems. Rather, I just want you and other investors to realize that you should have some reasonable basis for expecting the price of a stock to rise, and, with rare exceptions, that reasonable basis should be an improved outlook in the company's ability to generate earnings. (For detailed info on a company's earnings prospects, as well as other financial data to help you evaluate a stock, I suggest you check out our Investor Research Center.

To sum up, I'd say there's nothing to prevent you or anyone else from doubling down on a stock in hopes of a meteoric rise. That decision is in your hands. But when it comes to cashing in -- sorry, the consensus of other investors has the final say in that.


Walter Updegrave is the author of Investing for the Financially Challenged and can be seen regularly Monday mornings at 8:40 am on CNNfn.  Top of page






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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer. Morningstar: © 2018 Morningstar, Inc. All Rights Reserved. Factset: FactSet Research Systems Inc. 2018. All rights reserved. Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved. Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor's Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2018 and/or its affiliates.