about 3 years ago • 3 mins
What’s going on here?
This is a rare moment for markets. While it’s normal to pay a hefty price for shares of a small company with strong potential for massive future growth, the same isn’t typically true of the stock market’s largest members. The big question, of course, is whether buying this high makes sense.
What does this mean?
A glance at the Russell 1000 – an index of the largest thousand-odd US stocks – shows more of these big company shares trading at “extreme” valuations than at any time since the dotcom bubble. The chart below, produced by hedge fund Man Group, illustrates which sectors have and have had the most stocks trading with an “enterprise value” equivalent to more than 10 times revenue. (Enterprise value, or EV, is the value of a company’s outstanding shares plus its debt – basically what you would have to pay to buy the entire company).
While this may seem like a warning sign, it makes more sense when you remember that interest rates, even when borrowing for several decades, are barely above zero. These rock-bottom rates are responsible for many of today’s market oddities. And in the case of high-growth stocks – listed firms where sales and/or profit are growing much faster than average – a near-zero “risk-free rate”, when factored into standard valuation tools like the Gordon Growth Model, significantly increases what such companies are theoretically worth.
To quote Man Group: “in theory, a company with accelerating growth at a zero discount rate has no upper bound on its valuation.”
Why should I care?
This situation presents investors with a dilemma: if you want to buy a slice of fast-growing companies you’ll have to pay a pretty penny for the privilege.
For the right companies, however, pricey valuations are no barrier to future investor success. To purchase Google (now Alphabet) shares in 2005 or Amazon shares in 1999, you would have had to stump up over 20 times revenue at the time – a staggering valuation. But those who took this leap of faith have since been rewarded with respective returns of more than 700% and 4,000%.
A word of warning, though: just because you’re prepared to pay 10 or 20 times revenue for a stock doesn’t mean you’re getting the next Amazon or Google. You might equally be buying the next Sun Microsystems or (shudder) Pets.com.
While an expensive stock can turn out to be a good buy, it doesn’t follow that all expensive stocks are good buys. In fact, the opposite is true. History suggests that buying Russell 1000 stocks with an EV-to-sales ratio greater than 10 is more likely to prove a losing bet than a winning one over the following five years. (The chart below shows the mean average return in dark blue, the median return in light blue, and the returns of the 25th and 75th percentiles in orange and yellow, respectively).
Those willing to pay more than 20 times sales are even likelier to have lost out. At those valuations, there are a lot more losers than winners. So while some of today’s expensive-yet-fast-growing stocks will still turn out to be worth picking up at even elevated prices, it’s worth doing your homework on individual companies – and being very selective indeed as to which you reckon will work out in the long run.
Disclaimer: These articles are provided for information purposes only. Occasionally, an opinion about whether to buy or sell a specific investment may be provided. The content is not intended to be a personal recommendation to buy or sell any financial instrument or product, or to adopt any investment strategy as it is not provided based on an assessment of your investing knowledge and experience, your financial situation or your investment objectives. The value of your investments, and the income derived from them, may go down as well as up. You may not get back all the money that you invest. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment advisor.