ARE STOCKS TOO HIGH? By the old gauges of value, no doubt about it. But while merger mania lasts, the new math of takeovers and buyouts could keep pushing prices skyward.
By John J. Curran REPORTER ASSOCIATES: Christopher Knowlton and William E. Sheeline

(FORTUNE Magazine) – IN THE BULL MARKET of a lifetime, stocks had been streaking ever higher. Yet disquiet kept growing within the bosoms of enormously enriched investors. The market, after all, had whooshed beyond many of the time-tested value beacons by which prudent investors navigate. When the Dow Jones industrial average hit a high of 2722 in late August, the market sold at 23 times earnings per share in the last four quarters, a multiple not seen since the Dow's peak a generation ago. Even after an early-September drop, stocks in Standard & Poor's index of 400 industrial companies sold at three times book value on average, the highest level since World War II. By these yardsticks, it was time to run for cover. Yet few leave. Those who cash in their winnings are replaced by others with radically new perceptions of value and plenty of money to back up their convictions. These investors look beyond book value and earnings, taking their cues from takeovers, leveraged buyouts, recapitalizations, and other forms of corporate restructuring. What counts with the new breed is how a company's balance sheet can be rejiggered to raise shareholder value to undreamed-of levels. How much debt can the company carry? How much cash can it throw off? How many divisions can be surgically removed and resold for a bundle? Do these folks know what they are doing? So far, despite that sharp drop in the Dow shortly after the bull market entered its sixth year, the new doctrines, and the experts who espouse them, are looking great. The bulls have left cautious money managers choking on a cloud of dust. For the first time, some analysts and market watchers mention numbers they thought only their grandchildren would hear: 3500 on the Dow, even 4000. Just look at Japan, they say, where stocks sell at 77 times earnings. George Soros, 57, manager of the hugely successful Quantum Fund, is one of several sages who see peril as well as opportunity in the new formulas of valuation. A refugee from Hungary while still in his teens, Soros has spent his career detecting subtle shifts in investors' perceptions and delusions, most of the time profiting on both the upside and the downside. Since 1969 shares in his fund have grown more than 350-fold in value, and his personal stake accounts for several hundred million dollars of Quantum's $2.5 billion in assets. (Quantum is registered in Venezuela and it does not sell its shares to U.S. citizens except Soros and some other employees.) Looking at how much money Soros has made, and how fast he made it, some Wall Street professionals rank him ahead of even Omaha billionaire Warren Buffett as the most prescient investor of his generation. Some of Soros's early coups included forays into conglomerates and real estate investment trusts. Recently he has used highly leveraged futures contracts to make killings in the stock, bond, and currency markets. Soros thinks there's still money to be made. Bargains no longer predominate, he says, but a search quickly turns up stocks selling for less than a company's breakup value. More important, the cash and credit for takeover deals keep on flowing at home and abroad. But the forces that can carry investors to further winnings, Soros warns, are unreliable -- like a spindly World War I biplane ascending higher and higher above terra firma. The new game depends on more deals that shove values upward, and a willingness by acquirers and lenders to keep the money coming. But at some point stock prices, and the whole process, become unsustainable. The new ideas of value, Soros says, are the very stuff of booms -- and busts. To get a whiff of the danger, look at the chart on the facing page to remind yourself how far stocks have climbed. We are talking here about those household names that make up the S&P 500. Just a few years back the only place to rummage for shares that could take off was at the junk heap of small companies. Stock prices doubled, tripled, and sometimes collapsed as frail little outfits teetered between success and failure. Now it's the big guys who watch their stock prices climb. General Foods shot from $34 per share on August 12, 1982, the eve of the bull market, to $120 per share in 1985 when it was acquired by Philip Morris. Five summers ago Owens-Illinois, a humdrum packaging company, sold for about $10 a share. In March 1987 it left the Big Board in a leveraged buyout at a price that was 470% higher. Merck remains independent, but its stock has zoomed 578%, from $32 a share before the bull market to a recent high of $217, boosted by government approval of its new cholesterol-lowering drug.

TRADITIONALISTS concede that some of the market's advance is solidly based. After punishing years, the U.S. economic system is proving surprisingly resilient. Production is growing at a slow but steady pace, while interest rates and inflation remain at tolerable levels. The lower dollar promises to inject new vigor into many ailing industries, and productivity is rising impressively in U.S. factories (see Fortune Forecast). Further, the wave of corporate restructuring has been a boon to the bottom line: Earnings per share are surging. So stocks are worth more, all agree. Yet by one time-honored measurement -- their value compared with riskless bonds -- they look costly. Like a scorching sun, high interest rates shriveled the value of stocks during the late Seventies and early Eighties. The yield on 30-year U.S. Treasury bonds rose to 14%, and the average P/E multiple on the S&P 500 stocks shrank to less than 9. The easing of interest rates in 1982, all by itself, made stocks a more valuable alternative to fixed-income investments. The herd of bulls went thundering off. But T-bond rates bottomed more than a year ago at 7.2%, and have rebounded to nearly 9.5%. A sudden collapse in bond prices can give stocks a shiver, as happened in early September, but in general the Dow has ignored the uptrend in interest rates and kept on charging. At its latest high, it was up 44% in 1987 alone. The prospect of healthy profit increases through 1988 has surely helped. But even when highly optimistic earnings forecasts are fed into Wall Street's ''dividend discount models'' -- which securities firms use to estimate the present value of expected future earnings -- the models respond with a resounding ''sell.'' To those with strong allegiance to the old-time investing religion, all this is pretty ominous. Consider Alan Greene, president of David J. Greene & Co., a Wall Street money management firm that has achieved impressive gains over the past five years by following the principles of the late Benjamin Graham. Graham's book, Security Analysis, has become as dog-eared in many firms as a Southern preacher's Bible. It counsels investors to buy only stocks with low P/Es and low ratios of price-to-book value, all the while striving to keep the principal safe. As the market has zoomed, Greene has taken profits, boosting the percentage of cash in his portfolio to 25%. Not all his clients share his caution. ''We've lost a few,'' he admits. To Greene and others like him, this bull market is an alien creature: ''It used to be that when stocks sold at eight times earnings or three times cash flow they were cheap, provided that the company had reasonable balance sheets -- a low debt load. Now six times cash flow is considered cheap. And jeez, I don't know what a cheap P/E multiple is anymore. It's all relative. Balance sheets are being turned upside down. It's scary.'' Greene, for one, wonders if stocks can still sell at takeover-swollen P/Es when takeover activity subsides. Says he: ''We're all standing on quicksand.'' Are the traditionalists being a bit too cautious? Some well-known Grahamites, after all, considered the market fully valued as far back as two years ago. Clearly, something is going on that the old analytical concepts cannot account for. The prices offered in takeovers -- so-called transaction values -- are setting the market's pace these days. Takeovers have a sound aim: unearthing hidden value. One kind of buyer who sees a payoff in a potential acquisition is the direct competitor of a target company. When White Bread Co. swallows Whole Wheat Bread Co., it can eliminate many of the acquired company's fixed costs. Returns on the initial investment can be yeasty. These so-called strategic buyers, not surprisingly, have been willing to pay a premium over current stock prices for the right acquisition. But until the Eighties, strategic buyers had one moat they could not cross: antitrust rules. The government forbade significant increases in industry concentration. That quickly changed when the Reagan Administration's free- market policy threw down the drawbridge. New standards of allowable concentration were drawn up by the Federal Trade Commission, making it easier for competing corporations to wed. A five-year buying binge took off, lifting with it the valuations on scores of stocks. Just in the past 12 months or so Quaker Oats picked up Anderson Clayton; May Department stores spent $2.4 billion bagging Associated Dry Goods; Texas Air absorbed Eastern Air Lines. Observes Dennis J. Block, a partner at Weil Gotshal & Manges, a New York law firm that specializes in mergers and acquisitions: ''It is clear that many of the mergers you see taking place today simply would not have been allowed ten years ago. The threshold of what is acceptable industry concentration is clearly higher.'' THE GROUNDWORK for another part of the takeover movement was laid by some corporate misadventures back in the Sixties, when many companies went on acquisition sprees outside their core businesses. The promised synergies and other benefits from the conglomerate movement were often illusory. Nevertheless, the conglomerate wave stored up plenty of assets in corporate closets. These assets later provided another rationale for bidding up stock prices. As the Eighties dawned, a new breed of investor began to emerge, with entrepreneurial instincts and a bundle of cash he could use to pry loose those assets. This new bidder saw that he could amass great wealth by buying control of a lumbering giant and busting it up. He had to pay a premium over the going market price of the shares, but the hidden assets were worth it. Those fearsome raiders profiled in the following article appeared on the scene. T. Boone Pickens, Carl Icahn, and others used massive infusions of credit or junk-bond financing to acquire corporate giants many times the size of their own companies. Foreigners joined the game too, taking advantage of the lower U.S. dollar. Many foreign buyers covet American companies for the simple reason that they want a stake in the world's biggest market. In March, Rupert Murdoch's News Corp., the media empire based in Australia, agreed to pay $65 a share for Harper & Row, nearly three times what the book publisher had sold for in the market just one month before. In August, London-based Hanson Trust gobbled up conglomerate Kidde Inc. for $67 per share, double the previous market price. And Britain's Blue Arrow paid a fat premium for Manpower Inc., the personnel agency. Some foreign buyers enjoy yet another kicker. Blue Arrow has taken advantage of a high stock price in its home market and made an equity rights offering to existing shareholders -- a way of quickly selling additional shares at a discount -- to finance its bid for Manpower. Says Bill Lambert, a managing director in the mergers and acquisitions department at First Boston: ''It's obvious that some of these foreign acquisitions are being financed with very cheap sources of capital. It's got to be a motivating factor in the price they are willing to pay.'' In the current wave of takeovers, the theoretical schoolbook value of a company is almost beside the point. What does it matter, the bulls ask, if the value of a company, based on its expected earnings, figures to be $30 per share? Who cares about that if a raider or a foreign buyer is slapping $70 per share down on the table? It's cash, it's real -- it's value. Stocks that still sell below the breakup value of company assets are prime prospects for revaluation. Stocks that sell below their breakup value and have lots of assets or cash that could support a big new line of credit are doubly enticing. Each month Wall Street houses churn out lists of companies that fit these criteria. Even if no bidders appear, the stocks move higher anyway in anticipation of a bid from some corner. By now, managements have caught the religion. At first reluctant, they pound at the door of consultants who can teach them the way to a higher stock * price -- a price so high it would thwart even the most determined raider. Companies that fail to play the new game find the new rules imposed on them. In 1986 Richard Ferris, chief executive of UAL Inc., was quietly pursuing a long-term strategy to build an integrated travel company. But Coniston Partners, an investment boutique that specializes in putting asset-rich companies ''into play,'' spied pieces of UAL, since renamed Allegis, that could be sold off for a much higher combined price than the stock's price of $55 per share. Before long Ferris was out as chief, and investors were looking anew at the company's value. Since Coniston first announced a stake in Allegis, the stock has taken off and continues flying toward the perceived breakup value, which analysts put at about $107 per share. The stock recently sold at $97. A chunk of that value was realized in early September when Ladbroke, a British leisure conglomerate, agreed to acquire Allegis's Hilton International hotel chain for $1.1 billion, financed through an equity rights offering. Where did the perception of added value come from? Keith Gollust, a founding member of Coniston Partners, says it stems from the ability to borrow money to buy companies ripe for breakup. ''For the foreseeable future,'' says Gollust, ''the value of equities is going to be very closely tied to the amount of liquidity in the debt markets.'' The prices offered, he adds, could move up or down: ''Valuations today depend upon the leveragability of the target company, and that's something that could change very quickly. It's very speculative. At the market's current levels, changes in the financial environment could have a dramatic impact on valuation.'' Translated, that means the wings could easily drop off stock prices. Money manager Soros sees nothing unusual in this precarious state of affairs. In his new book, The Alchemy of Finance, which examines the inner psychological workings of the stock market, Soros flatly rejects the idea that stock prices are fundamentally sound reflections of the underlying worth of companies. Stock market valuations, he says, are ''always distorted'' by the ongoing biases of investors, lenders, and regulators. THAT PUTS SOROS at the opposite pole from believers in the efficient-market hypothesis, which holds that stock prices quickly change to take account of all available news about the earnings prospects and general health of companies. He marches under the banner of what he calls ''the theory of reflexivity.'' The theory, which he applies to currency markets as well as stocks, holds that the prices investors pay ''are not merely passive reflections (of value); they are active ingredients in the act of valuation.'' One example Soros offers of how this theory plays out in the market: In the Sixties, the high prices of conglomerate stocks enabled companies to step up their buying sprees. This policy pushed prices even higher until the stocks collapsed. Examples of reflexivity abound these days too. A weak company with a low stock price has trouble raising money, and this drives the shares down further. Prices offered in takeover bids, on the other hand, can lead to a revaluation of a company's assets. That makes bankers willing to lend more to other bidders, which in turn can lead to still higher bids. Ultimately the process of valuing reaches its limits as prices go beyond all reason. Soros thinks that while the market is already unstable and overvalued, it has not yet reached the point of collapse. Indeed, it could yet move much higher. The upward march could stumble if some of the highly leveraged takeover deals being done today start going belly up. Mark Solow, a senior managing director in charge of Manufacturers Hanover's multibillion-dollar portfolio of loans to finance leveraged buyouts, thinks that melancholy turn of events is only a matter of time: ''In the existing euphoria, everyone thinks that these deals can't go bad, that it's like taking candy from a baby.'' Solow says the scariest deals are those his bank turns away. ''I'm talking about the ones that are so shaky, you don't even try. Then you see those deals get financing somewhere else.'' Solow points to overly optimistic cash flow projections in many LBO plans he sees. ''There's no contingency for an economic downturn,'' he says. He also sees evidence that many of today's LBO participants who expect to sell off pieces of the company at high prices are counting on the bull market, rather than on an improvement in the company's fortunes, to bail them out. ''As a result of the bull market,'' he says, ''the expectation for higher values on asset sales has grown.'' So far, says Lambert of First Boston, ''that has been a good underlying assumption.'' Indeed, transaction values continue to beget higher transaction values. Says Winthrop Knowlton, the former chairman of Harper & Row who helped negotiate the sale to Murdoch's News Corp.: ''There is a ratchet effect here. As people pay more and more for companies -- higher multiples of book value or cash flow or whatever you want to use -- all the subsequent acquisitions in that industry are keyed to it. You look around at the prices of comparable companies in the industry, and they all go up.'' What Knowlton describes has been under way for some time. In 1985, when R.J. Reynolds Industries bought Nabisco Brands for $4.9 billion, or 3.2 times book value, the prices of all other food stocks quickly lurched up to reflect the upgraded valuations. Many of the big transactions that set the tune no longer bear any relation to the intrinsic value of the firm. Knowlton observes that while the price-to-book value and price-to-revenue multiples for publishing companies are rising on the coattails of new deals, the industry's real performance numbers are getting worse: ''A lot of companies in that business are struggling. The competition has become more fierce, and margins are under pressure.'' Some investors, no doubt, have caught on to the increasing hazards of the game. One sign comes from statistics compiled by the Alcar Group, a research firm in Skokie, Illinois. The figures reveal that in the Eighties the stocks of hostile bidders have tended to fall in the weeks following the successful bid, a sharp reversal from the pattern of earlier years. Conclusion: Investors fear that raiders may be overpaying. YET BREAKUP VALUE still exerts a strong upward pull on stock prices. As the table below shows, several companies in the food industry sell for far more than can be justified by even a rosy estimate of the payoff from tighter, leaner management. The calculations were made by Alcar, which advises companies on how to raise the value of their shares and ward off raiders. But what if you took the company apart and sold it off in pieces? The breakup values used in the table are estimated by Alan Greditor, a food industry analyst at Drexel Burnham Lambert. Greditor's figures are closely watched by institutional investors who respect his record in spotting the untapped value in companies. Investors are still quite willing to accept the implied breakup value of companies as a guide to the true worth of stocks. Says Alfred Rappaport, chairman of Alcar: ''What investors are saying with recent stock prices is that they expect someone to realize the breakup value of those firms. If it's not current management, then it will be someone else.'' Rappaport advises his clients to accept these new valuations as a fact of life. He also teaches companies to focus not on earnings, an accounting concept, but on the cash flow -- retained earnings plus depreciation -- that actually pours into the coffers. And he urges many clients to leverage up by taking on more debt. These days, if the breakup value of a company far exceeds the market price, it can play the latest Wall Street gambit: a ''leveraged recap.'' It borrows tons of money and pays the shareholders a cash windfall. The fact that companies can do this -- or some raider can do it for them -- gets reflected in the stock price. Investors who navigate by breakup value are playing an increasingly dangerous game. Even if lenders remain willing to finance the takeovers that lead to breakups, other developments could weaken today's stock valuations. The same regulatory drawbridge that was let down five years ago, freeing companies to buy competitors, could be pulled back up. Several states have passed new laws curbing takeovers. The increasing debt on the books of U.S. corporations poses another risk. As the chart on page 30 shows, the corporate push to leverage up has lowered such critical ratios as companies' coverage of interest expenses by cash flow. The numbers shown are only for publicly traded industrial companies in the S&P 400. What they do not show is what has happened to companies that have dropped out in takeovers and LBOs, where the leverage is presumably much greater. Interest coverage does not tell the whole story. Managements can improvise in a pinch, cut expenses, trim capital outlays, do any number of things to raise cash. Perhaps the most valid reading of corporate debt levels comes from the mood of managements who must live with those heavier loads. A recent survey of 250 financial executives conducted by Clayton & Dubilier, a New York-based leveraged buyout firm, reveals that 50% thought current debt levels were too high. Only 34% felt current levels were appropriate. Such concerns are not irrelevant to the valuation of stocks; they are an integral part of it. An immutable dictum of investing is that you should strive to preserve the safety of your principal. There is no way to escape the ups and downs of the market. But what Benjamin Graham meant when he set down that rule of value investing was simply that the money invested should have a good prospect of surviving. Take a higher risk than that, Graham said, and you are moving into the realm of speculation, not investment. That stocks have moved up, up, and away from the fundamental measures of value does not mean they must tumble. Says Soros: ''Just because the market is overvalued does not mean it is not sustainable. If you want to know how much more overvalued American stocks can become, just look at Japan.'' Even after an adjustment is made for the peculiarities of Japanese accounting, Japanese stocks sell at P/Es of about 60. Soros thinks that those multiples rule out a happy landing for the Tokyo market: ''There's no turning back for the Tokyo market. The perception of value has become so extended, an orderly retreat seems impossible. There may be a crash coming.'' SOROS'S PESSIMISM stems from the ''reflexive'' nature of Japan's run-up. Many Japanese companies, especially banks and insurance companies, have big percentages of their total capitalization invested in the stocks of other Japanese companies. Some even issue debt to finance stock market investments. While such a big stock market exposure has sent these companies' valuations flying up as the Tokyo market rose, it poses a similar threat on the downside. Because of that, Soros believes, anything more negative than a brief market downturn would likely trigger an implosion of Japanese stock values. With the Japanese market now representing 36% of all stock values worldwide, such a quake would surely send tremors around the world. The U.S. market might get off with light damage. The valuations of American stocks are nowhere near the nonsensical levels in Japan, though many of the same processes that led to those extreme valuations are already under way. Soros cautions that if the Dow Jones industrial average races madly ahead, say to 4000, a bust is in the cards. For now, he says, the best thing would be a long, quiet pause. Yet he is basically optimistic: ''The American market has only recently gotten carried away, and it can still correct these excesses in a mild, orderly fashion.''

BOX: THREE READINGS OF THE MARKET These are treacherous times for stockholders, if you believe Morgan Stanley's dividend discount model. Like similar valuation formulas widely used on Wall Street, it estimates the value of stocks compared with a riskless alternative: Treasury bonds. Morgan Stanley figures that in mid-August the stock market was way above fair value by this yardstick. Nonsense, counter those who pull off leveraged buyouts at ever higher prices. FORTUNE estimates that this crowd has lately been paying 3.5 times book value, on average, to acquire companies. Meanwhile, however, the rising corporate debt burden has weakened companies. This causes some analysts, who cite the declining ratio of corporate cash flow to interest expenses, to wonder if the market has indeed risen beyond the underlying value of companies in the S&P 400.

CHART: TEXT NOT AVAILABLE CREDIT: SOURCE: MORGAN STANLEY CAPTION: Overpriced, according to a Wall Street yardstick based on corporate earnings. DESCRIPTION: Stock prices as percent of fair value according to dividend discount model, 1970 to 8/14/87.

CHART: TEXT NOT AVAILABLE CREDIT: SOURCE: MERGERS & ACQUISITIONS MAGAZINE CAPTION: Not so, say the architects of leveraged buyouts. DESCRIPTION: Price paid in leveraged buyout deals as multiple of book value, 1981-1987.

CHART: TEXT NOT AVAILABLE CREDIT: SOURCE: S&P ANALYST'S HANDBOOK: COMSTOCK ESTIMATES CAPTION: Maybe, say those who worry about companies' declining ability to service heavy debts. DESCRIPTION: Pretax cash flow as multiple of interest on debt for Standard & Poor's 400 industrials, 1967-1987.

CHART: TEXT NOT AVAILABLE CREDIT:ILLUSTRATION BY DANIEL MAFFIA SOURCES: LIPPER ANALYTICAL SECURITIES, VANGUARD GROUP, AND FORTUNE ESTIMATES CAPTION: IF YOU HAD INVESTED $100,000 IN 1982 . . . . . . YOUR MONEY WOULD HAVE GROWN TO $395,000 The total returns in the bull market dwarf even the dizzying climb of the averages. On September 1, a portfolio whose performance matched Standard & Poor's 500-stock index, counting reinvested dividends, stood at nearly four times the figure five summers ago. DESCRIPTION: Value of $100,000 stock investment, August 12, 1982 to September 1, 1987. Color illustration: Bull and bear fighting.

CHART: COMPANY VALUE PER SHARE RECENT PRICE BREAKUP VALUE under management's strategies

CPC International $49 $53 $82

General Mills 41 56 86

Gerber Products 30 51 69

Kraft 47 58 90

Ralston Purina 95 86 149

$ CREDIT: SOURCES: DREXEL BURNHAM LAMBERT, ALCAR INC. CAPTION: HOW HYPOTHETICAL PRICES HOIST REAL PRICES Influenced by breakup values, stocks at most of these food companies have already passed the levels their bosses are struggling to achieve. DESCRIPTION: See above.