The debate whether lodging stocks are fairly valued may boil down to the fundamental difference between valuation for stock-buying purposes versus what constitutes a good company with profitable and valuable underlying assets. In other words, what makes a strong company may not necessarily qualify in the New Economy as an attractive stock-buy for an investor in search of high returns within a short time span.

The Issues

Hotel companies claim that investment banking security analysts should do a better job of educating the investing public on the intricacies and risks of the lodging industry. Security analysts, and therefore many investors in the stock market, have a view that hotels are past their plateau, and are trending downward in terms of profits and asset values. Ever since the credit crisis of August 1998, a psychology has been set off that hotels are a bad risk, and the industry�s stocks have not really been able to recover much since (Exhibit 1). Although hotel stocks are up for the first seven months of 2000, they are up from very low levels and are well below their 1998 highs. As a result, it remains difficult to make a strong argument to the bulk of investors in the stock market that the reward potentials are attractive when hotel companies are compared to the profusion of investment alternatives on a risk/reward basis.

The continuation of stable U.S. economic expansion has helped keep the demand growth for hotel rooms on the order of 3.0 percent or above for the past several years. Nevertheless, U.S. hotel room revenue growth, as measured by revenue per available room (RevPAR), has been slowing since 1997 (Exhibit 2). RevPAR growth, considered by security analysts to be a key catalyst for moving lodging stocks, is also being impacted by the Internet, s consumers are shopping on-line for the best hotel room bargains. 

But to what extent are these claims true? Are hotel stocks fairly priced or under-priced in the New Economy? If hotel stocks are underpriced, why aren�t investors rushing to buy them? Aren�t the securities markets supposed to be the ultimate determinant of what is an appropriate valuation for hotel stocks? The big question is: have traditional Wall Street valuation parameters become obsolete in the New Economy?

Hotel Sector Fundamentals

At its core, the hotel business is one of real estate, centering around the buying, selling, and renting of space. Hotels are a unique breed of real estate as they are capital- and labor-intensive. To assess whether lodging stocks are fairly priced or underpriced, it is first important to lay out the inherent risks and potential rewards within the hotel industry. Exhibits 4 and 5 bring to light that, despite inherent risks in lodging, there are also material rewards. 

With interest rates rising, the value of the future is discounted. Higher interest rates make it harder to earn those profits. The rise in interest rates will also cause P/E multiples to decline.

Because a hotel is not just real estate, but a business that requires intense and competent management, contracting a suitable management company is crucial to the hotel's success. The three most important areas are marketing (branding), service, and cost control. 

Edward Yardeni, chief economist of Deutsche Bank, has observed that "valuation, like beauty, is in the eye of the beholder". What rankles hotel companies is that lodging stocks are trading below what their underlying properties would be worth if they were sold tomorrow, and that the market�s punishment has been indiscriminate. Exhibit 6 brings to light that the stock prices of lodging C-Corporations (those operating as regular business corporations) are out of line with their intrinsic worth, although it is important to realize that when a company�s stocks are bought, its future earnings are being acquired, not its tangible assets. History shows that capital market psychology and human reactions can affect stock prices more than industry fundamentals. In other words, the stock market should be considered more as a voting process rather than a weighing process that is dictated by carefully-thought-out calculations and basic arithmetic.

According to legendary investors Benjamin Graham and David Dodd, at the beginning of the 1900s the investment in stocks was based on the threefold concept of:

1. A suitable and established dividend return;
2. A stable and adequate earnings record; and
3. A satisfactory backing of tangible assets ².

Since the 1930s, the notion that the value of a stock depends entirely upon what it will earn in the future has become paramount, and the financial markets have since refused to grant any importance to the underlying asset values behind stocks. Research indicates that future earnings show no tendency to be controlled by the amount of the actual investment in the business (the asset values), but instead, dependent upon a favorable industrial position and upon fortunate managerial policies ³. In other words, current stock investment logic (whatever truth or justification may lurk in this generalization) is based on the following:

1. The value of a stock depends on what it can earn in the future; and 
2. Good stocks are those which have shown a rising trend of earnings.

1. ^{Average Net Asset Value (NAV) derived from valuation estimates compiled by analyst Michael Rietbrock of Salomon Smith Barney.} 
2. ^{Represents discount of Average NAV relative to the stock price as of 12/31/99. Discount to NAV calculated by PKF Consulting.}
3. ^{Diluted earnings per share growth rates.}

The sample of ten lodging C-Corps in Exhibit 6 have five-year growth rates ranging from eight percent to 28.6 percent. According to Marketguide, Inc., the lodging sector had a 1999 P/E ratio averaging approximately 15 times earnings, close to half the 1999 S&P 500 P/E multiple of 27.4x. With worries of overbuilding still lurking over the hotel sector and rising interest rates, the lodging C-Corps� estimated P/E ratios are projected to drop further in 2000. P/E multiples essentially indicate the value investors place on a company�s earnings, while growth rates are of importance as they convey the trend of earnings, a very useful indication of investment merit. A high P/E multiple for a company is good because it indicates that the investing public considers the company in a favorable light. A decrease in the P/E ratio reflects decreasing investor confidence in the growth potential of the company. A low P/E ratio, coupled with a high earnings growth rate, can also indicate that a stock is under priced. Exhibit 6 highlighted that although hotel stocks do have low P/E multiples, they are accompanied by what is considered by the stratospheric standards of the New Economy as middle-of-the-road earnings growth rates.

As a comparison, the sample of ten companies in other sectors (Exhibit 7) have a projected earnings growth rate ranging from 17.5 percent to 60.1 percent, and estimated 2000 P/E multiples extending from 8.2x to 501.9x. Investors basically look where valuations are low and at businesses that have the possibility of earning high returns. With low valuations that are accompanied by comparatively "average" earnings growth rates, why should investors buy lodging stocks in the New Economy? Does the investing public sense that there are only little games that hotel companies can play to get their stock bought, but long term, they cannot get dramatic growth? A select few hotel stocks such as Four Seasons, Marriott, and Starwood can, nonetheless, provide possible security, if not serenity, in investing in bricks and mortar, especially as investors are increasingly becoming more nervous about the broader market and questioning valuations.

Lodging is a consumer cyclical industry, and cyclical industries have historically traded at premiums during the up side of the cycle and at a deep discount during the down side. Although Exhibit 2 indicates that a slight improvement in RevPAR growth is estimated for 2000, competition from tech stocks, as well as aggressive growth funds, should still be imminent, dampening demand for lodging stocks. In 2001, supply risk should subside and RevPAR should post higher growth rates. By 2002, a sustained upswing for lodging stocks could occur. However, such a recovery scenario is partially contingent upon tech stocks tumbling and remaining low for an extended period, an event the timing of which is impossible to predict. Investors who owned hotel stocks between 1996 and 1998 (when hotels were being acquired significantly below their replacement costs and lodging C-Corps were attaining growth rates in the 30-percent range), did so for growth and momentum. Investors who have opted to hold them since that time are considerably more patient, willing to wait it out a couple of years. 

In the New Economy, hotel stocks are obviously not for high-yield-seeking day traders and momentum investors, but rather for long-term value-oriented investors who can stomach an industry whose earnings growth is dependent upon the vagaries of the world�s economy. For now, viewing hotel stocks simply as inexpensive stocks might be wiser than considering them as significantly undervalued by Wall Street.

^{NM: Not meaningful.}

^{Source: Bloomberg Financial Markets and I/B/E/S International}

Beta ⁽²⁾

P/E High � Last 5 Years

P/E Low � Last 5 Years

Sales � Proj. 5-year Growth Rate

Earnings � Proj. 5-year Growth Rate ⁽³⁾

EBITDA Margin � Last 5-year Average

Net Profit Margin � Last 5-year Average

Return on Investment � Last 5-year Average

Return on Equity � Last 5-year Average

^{(2) Beta measures a security�s volatility relative to an average security, and is a measure of a security�s return over time to that of the overall market. A Beta of 2.0 means that a security is twice as responsive, or risky, as the market, which has a Beta of 1.0. Hotel stocks, with a Beta of 0.65, are only nearly half as risky as the market.}

⁽³⁾ Diluted earnings per share growth rates.

Source: Marketguide, Inc.

As Wall Street is obsessed with earnings and growth rates, the following provide some options/strategies that public hotel companies can pursue in order to boost their earnings, thereby making their stocks more desirable.
 

If all else fails, some hotel companies should consider going private. Being a public company is a viable option if the company is ready and capable of rapid growth. But with average growth levels, the option of becoming privately held could be attractive, primarily for the small lodging C-Corps. In the Old Economy, public hotel companies realized a value arbitrage that doubled their value simply because they had access to capital. With tighter access to capital, such a benefit has diminished. Moreover, as the public markets have difficulty measuring asset appreciation and underlying tangible asset values, the rewards of being public are reduced. Lastly, hotel companies with market capitalizations of less than $1.2 billion have very high reporting costs that can impact their bottom line. 

Conclusion

Given the supply-side risk currently impacting the hotel sector and anemic RevPAR growth rates, would it be prudent to say that lodging stocks are fairly priced within the paradigm of the New Economy? Based on Wall Street investment parameters, the answer appears to be yes. For those involved in the hotel sector on a day-to-day basis, the answer is no. But Dodd and Graham remind us in their 1934 classic, Security Analysis, that "It is customary to refer with great respect to the bloodless verdict of the market place, as though it represented invariably the composite judgment of countless shrewd, informed, and calculating minds. Very frequently, however, these appraisals are based on mob psychology, on faulty reasoning, and on the most superficial examination of inadequate information". ⁶

Anwar R. Elgonemy is an Associate with PKF Consulting, an international real estate advisory firm headquartered in San Francisco.

Notes:

1. F.W. Dodge construction pipeline data.
2. David Dodd and Benjamin Graham: Security Analysis, Whittlesey House, New York, 1934, Page 307.
3. Ibid., Page 308.
4. Salomon Smith Barney, The Lodging Stocks, February 2000, Page 102.
5. C. F. Sirmans: Real Estate Finance, 2^nd Edition, New York, 1989, Page 410.

David Dodd and Benjamin Graham: Page 369.