In investing, few concepts are as important (and as misunderstood) as valuation. Whether you're buying a rental property, a privately owned company, a single stock, or investing in a broad index fund, the price you pay relative to the underlying value of the asset plays a major role in your long-term returns
Valuation Matters
Take Zoom (ZM) for instance. Zoom provides the video service that became so popular during the COVID lockdown. The company saw a tremendous boost in revenue and earnings in 2020 compared to 2019. Revenue increased from $540 million to $1.97 billion. Net income jumped from just $16 million in 2019 to $427 million in 2020. Zoom was growing quickly, and investors climbed on board for the ride. After hitting a low point of $59.94 in October 2019, the stock went on one of the most epic runs in Wall Street history, hitting a high of $588.84 in October 2020; nearly a 10x return in a 12-month time span.
Zoom finished 2020 with a market value of $96 billion. Based on their net income for the year ($427 million), the Price/Earnings ratio at the end of 2020 was 232.6. In other words, investors were paying $232 per $1 of earnings (stock price divided by earnings). Regardless of the business and the growth prospects, this is a high price to pay per dollar of income. Imagine a snow cone stand generating $10,000/year in income. Would you dream of paying $2.3 million to purchase that business? Yet, investors blindly piled into the stock believing that revenues would continue to increase and earnings would continue to compound.
And here is the crazy thing… that’s what happened. Over the next 5 years, Zoom’s revenue nearly tripled. Net income also increased, from $427 million to approximately $1.2 billion. The “book value” of the company assets increased sixfold. Zoom (ZM) stock, however, is trading at $83.99 per share at the time of this writing, a decline of 85% from the 2020 high.
How did this happen? The investment thesis was largely correct. Zoom was a growth stock that continued to grow. But valuation matters. Investors were so optimistic about the long-term prospects that they completely ignored the price they were willing to pay to purchase the future growth of the company.
The same story could be told for many of the other COVID darlings, such as DocuSign, Etsy, and PayPal. Each of which has seen considerable increases in earnings and revenue, only to have their stock prices decline by 50% or more from their 2020 peak due to investor overvaluation.
There are countless examples of the same phenomenon from the late 1990s, such as Cisco (CSCO), which briefly became the most valuable company in the world in March 2000. Investors were willing to pay as much as $150 per $1 of earnings at the peak of the bubble. Cisco's stock would fall 88% over the next two years as the hype faded and valuation came back to earth.
Oracle (ORCL) and Qualcomm (QCOM) were caught up in the tech bubble of the late 1990s as well, with P/E ratios surpassing $100 per $1 of earnings. Both stocks declined more than 80% by 2002. By 2005, Oracle’s P/E ratio was down to 22.2.
Each of these companies was successful. The investor thesis of the dot-com era was largely accurate. The internet changed the way we conduct our lives, but the hype led to dramatically overpriced stocks and subpar future returns. And those are the success stories. Most companies in the dot-com era went bankrupt or never reached their potential. Competition eventually entered the market, eroding profit margins and market share.
Is This Time Different?
Artificial intelligence has become a driving force in stock market returns over the last couple of years. AI may wind up being just as impactful and transformative to our lives as the internet. But how will investors perform?
Valuations are concerning, and it’s not just tech stocks. At the time of this writing, investors in the S&P 500 are paying $30.58 per dollar of earnings, ranking the current P/E valuation in the 98th percentile over the last 100 years. In other words, you’d be hard-pressed to find a time in which investors are paying a higher price to own stocks in the history of the stock market. Aside from the Great Recession of 2008-2009, when earnings cratered, the only time investors were paying more per dollar of earnings was during the latter stages of the dot-com bubble.
Given the small sample size of similar historic valuations, it’s unfair to draw conclusions about the future returns of stocks, but it’s worth noting that the S&P 500 peaked at 1550 in March 2000… and March 2013 despite continued earnings growth. Yes. You read that correctly.
Earnings expanded over that 13-year window, but starting valuations were too high to reward investors. I fear that we may be in for a similar experience, and suspect that returns over the next 5-10 years are likely to look considerably different than the returns we’ve experienced over the last decade.
Justifying the Valuations
Why are investors paying so much per $1 of earnings? High valuations stem from a combination of factors. The reality is that profit margins are higher than average, earnings growth has been stronger than expected, interest rates are expected to decline, and regulation is softening for many sectors of the economy. All of these are tangible factors that improve market conditions.
There is also an underlying optimism that AI will make workers more efficient, cut costs, and lead to even higher profit margins in the future. All of that is possible. But the future beneficiaries of the AI revolution may be much different from the companies that have benefited up to this point.
NVDA has been able to increase earnings at a staggering clip of 59.3% per year over the past 10 years. That’s amazing, but it isn’t unique. Cisco (CSCO) had a similar run from 1992-1999 in which earnings grew at a compounded rate of 46.2%. Qualcomm (QCOM) grew earnings by 52%/year from 1991-1998. The optimism in the late 1990s was similar.
The point is that stock valuations matter. Eventually, investor optimism wanes and returns to “normal levels”. Growth slows. Maybe competition increases. Perhaps demand sours. The AI growth story might produce less benefit than expected. Sometimes employees get rich and lose their edge. The Economic Times reported in August that 80% of all NVDA employees are worth more than $ 1 million, and half of the workforce has a net worth of more than $25 million due to employee stock options and stock purchase plans. Anecdotally, if I were worth $25 million, I would reduce the number of hours I spend at the office. Perhaps NVDA can maintain its edge. Perhaps the crazy run isn’t over, but if NVDA’s stock continues to increase at the same rate as the last decade (77% annualized), the company would have a market cap of $75 trillion in 5 years, which is double the size of the entire US economy… which seems unlikely.
So, what should investors do?
In the short run, momentum is strong. Investors are optimistic, and the Federal Reserve is being accommodative. Inflation is in check. The unemployment rate is low. There is no reason to expect the market to change course in the near future. Valuations are a bad timing mechanism in the short run. If investors are comfortable paying $30 per dollar of earnings, they may very well be comfortable paying $35. Earnings growth is still strong. The market could still move higher. But it’s worth remembering the lessons from the dot-com era. This is not unprecedented. Enjoy it. Embrace it. But remember that it isn’t normal. There will come a time when investors’ risk appetite will change, and stocks will reprice closer to historical norms. Valuations will become a headwind, and a generation of investors will be surprised that stocks don’t always go up.
We will continue to ride this wave while we can, but we are keenly aware of the elevated valuations, and our concern is growing. We will continue to hold an allocation of bonds, and cash can help dampen the volatility. We are also increasingly utilizing risk-managed investments (but that’s a whole other blog post).
As always, we are appreciative of the trust you place in us. We don’t take it lightly, and we will do our best to navigate whatever the future holds.
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