What we are looking for
How the valuations of the “Magnificent Seven” look under closer scrutiny.
The Magnificent Seven refers to a group of growth companies that comprise seven of the eight most valuable U.S. companies. Together they are roughly equal to the value of all publicly listed stocks in Canada, Japan and Britain combined. The two largest – Microsoft and Apple – are by themselves worth more than the entire Canadian stock market.
Last week, Ian McGugan made the point in The Globe and Mail that while these stocks appear overvalued when using the most common way to value a stock – its share price in comparison with its last year of earnings per share, or P/E ratio – many look reasonably priced when using a PEG ratio (P/E divided by earnings growth), which factors in the “breakneck pace” at which these companies are expanding their profits.
Another interesting consideration is what is, and more importantly, what is not, included in the earnings figures which underpin the headline P/E ratio. The author of the article stated that: “Bulls will tell you that you can’t afford not to own these high-tech giants at a time when AI is poised to reshape economies.” These companies are spending an enormous amount on research and development on AI, as well as other promising technologies.
In decades past, R&D was considered more speculative, with the value companies might ultimately realize from it relatively uncertain. This is reflected in accounting rules, which dictate that R&D spending, rather than being capitalized on the balance sheet and reflecting an increase in the company’s assets, is expensed and thus lowers reported earnings for the year in which it is spent. This has the effect of lowering the book value of a company’s assets, increasing its price-to-book ratio. It also lowers reported earnings, increasing its P/E ratio. Both of these effects makes these growth stocks appear overvalued relative to companies in other industries, which spend less on researching promising new technologies.
For investors who feel that the money being spent by these tech giants on research is likely to bear fruit, it might be sensible to view the companies’ share prices relative to an R&D adjusted earnings figure that reflects this.
The Screen
- We look at the R&D expense line item for each company and add this back to reported earnings to calculate an adjusted P/E that might better reflect economic reality.
- For income-oriented investors, we look at the analyst consensus forecast for dividend yield for the year ahead.
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What we found
Each of the Magnificent Seven looks significantly more attractive from a valuation standpoint without its R&D spend deducted from earnings. For investors looking for high growth potential, a modest dividend, and a P/E no more than 30 – an admittedly arbitrary, round number – Apple, and especially Microsoft, the world’s most valuable company, still look like a good buy.
Hugh Smith, CFA, MBA, is Director, Analytics at London Stock Exchange Group.