What’s the deal with valuations?
We feel like Jerry Seinfeld right now, but we’re not the only ones. During the early-August selloff, investors weren’t just panicking over July’s surprisingly rough jobs numbers—they were also worried that big tech’s spending on AI won’t deliver big-enough profits.
Are some stocks overvalued? To get a handle on how valuations are trending, we asked an M&A adviser and a money manager to share what they’re seeing. But first, let’s set the stage.
Where we’ve been. For more than a dozen years, the price-to-earnings (P/E) ratio of the S&P 500 has generally been on an upward march. But soon, major indices might find that multiple heading in the opposite direction. P/E ratios for the S&P 500, Nasdaq 100, Dow Jones Industrial Average, and the Russell 2000 are each projected to fall in the next year, according to Aug. 9 data from Birinyi Associates, the Wall Street Journal reported.
Downhill from here? Chris Bloomstran, money manager and founder of Semper Augustus Investments told CFO Brew that he believes valuations hit a secular peak in 2021 and that it’s a matter of time before the market responds with a slowdown. The recovery of earnings multiples after a 2022 selloff have been limited to the 50 or 60 largest companies, he said, and in many cases their resurgent valuations aren’t justified given their falling revenue growth and, in some cases, the likelihood that their profit margins will narrow. He brought up Apple and Costco—which this summer have been trading at more than 30 and more than 50 times earnings per share, respectively—as examples of companies that can’t justify their P/E ratio with future earnings. Both are likely to spend the next 10 years with topline growth below 10% and “with little room to increase margins,” Bloomstran said in an email.
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Bloomstran predicts that the market will eventually reckon with slowing revenue and earnings growth at some of the largest US companies and, when they do, that share prices will also “grow much more slowly or even decline.” Likening the decade ahead to the one that followed the dot-com bubble, he believes the S&P 500’s “best-case” scenario is an average annual return of 5%.
Thoroughly shook by the predictions, we sought out someone with an on-the-ground view of how valuations have been shaking out.
I saw the sign(s). While Kevin Desai, partner in PwC’s deals practice, has noticed signs that valuations might fall, he said what he’s mostly seeing, so far, is the status quo Desai told CFO Brew in an email that EBITDA multiples of companies involved in deals “have been relatively stable” lately, both for deals he’s advised on and those he’s seen elsewhere. PwC’s practice hasn’t seen a mismatch between asks and bids on deals that have closed, he said, but “we are seeing a rise in busted sale processes” that lead to a deal falling apart, he said, “often because a widening bid/ask spread.”
The divide between buyers and sellers “has widened the furthest in industries where the gap between adjusted EBITDA and operating cash flow is the widest,” Desai said. As leverage has gotten more expensive, investors have more closely examined “the cost of growth that does not manifest itself in EBITDA,” he added. They’re now more skeptical of industries with high capital expenditures or mostly inorganic growth.
A transition to lower valuations will take some adjustment, if recent deals are any indication. Companies have watched for years as markets grew and valued companies with “persistently high valuation multiples,” Desai said. As bidders come in with lower offers, he added, “sellers are reticent to realign their own expectations.”