Price-to-Growth Flow Ratio
Information-age companies need new methods of evaluation, ... don't they?
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According to Stephen R Waite ("Investing in the 21st Century", Global Equity Selection Strategies) new tools are needed to evaluate Information-Age companies.
Waite argues that machine-age yardsticks are no longer adequate -- a claim that now (2001) seems to have lost its force, with the crash in stock prices. But many new-age companies are human-capital-intensive and engage in a higher percentage of research and development than more traditional firms. In fact, book value as conventionally measured will become even less relevant as we move deeper into the information age, says Waite.
One reason for change is that replacement costs have been altered dramatically. It's one thing to talk about the replacement cost of machinery or a parcel of land, but quite another to refer to the costs of the products of research or the training and development of staff.
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It may be the case that the valuation ratios associated with information-age companies won't be sustainable, but in light of the fact that new-economy companies are more like highly adaptable eco-systems than the older machine-systems, it is still important to re-examine the traditional evaluation methods. Quoting Waite
At the heart of [the studies of the economic relations among organisms and their environment] is the notion that growth and corporate profitability are functions of organizational learning. Put simply, the higher the level of
organizational learning, the higher the level of corporate profitability and growth.According to Waite, a new approach developed by Michael Murphy is called the Price-to-Growth Flow Ratio, and is given as:
Price-to-Growth Flow Ratio = Stock Price Per Share/(EPS + RDS),
where EPS is earnings per share and RDS is the R&D spending per share. To get the value for the Price-to-Growth Flow Ratio, add the earnings per share and the R&D spending per share and divide the sum into the price of the stock. According to Murphy, a value below 4.0 makes a company attractive for investors.
A major problem with the indicator is that the value for earnings per share isn't defined for many companies, partly because much of their income is poured back into R&D. This could lead to a false reading from the valuator. But Waite suggests alternatives.
One of several possible variations of earnings per share is the use of cash flow per share. Another is to use "revenues instead of cash flow and get a modified price-to-sales ratio that adjusted for R&D spending."
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