By Andrew Bary
It’s getting to be a silly season for certain stocks.
The technology stocks propelling the S&P 500 have raced ahead while leaving much of the rest of the market behind. Valuations on the priciest tech stocks based on profits and sales are approaching the peak values reached in late 2021, before the big Nasdaq selloff in 2022.
Companies such as Cadence Design Systems, Cloudflare, and Nvidia trade for nearly 20 times projected 2024 sales, a calculation based on market value divided by estimated revenue. Even Microsoft, the world’s largest company at $3 trillion, is valued at more than 10 times estimated sales in its current fiscal year ending in June.
Once upon a time, 10 times sales was viewed as pricey. As Scott McNealy, the former CEO of Sun Microsystems, said 20 years ago, “At 10 times revenue, to give you a 10-year payback, I have to pay you 100% of revenue for 10 straight years in dividends.”
That theoretical exercise isn’t really feasible, because companies have significant costs and can return only a fraction of revenue to investors annually. McNealy’s point was that at high valuations, investors are relying on long payback periods to justify their holdings.
That 10 times sales level now is widely breached as favored growth stocks regularly trade for close to 20 times sales. Some 10% of companies in the Russell 1,000 index trade for 10 times sales or more.
It isn’t just tech companies. The five companies with the highest price/sales ratios in the S&P 500 index that have market values of $50 billion or more include Visa, Eli Lilly, and robotic-surgery leader Intuitive Surgical. Arm Holdings, Wingstop, Costco Wholesale, and WD-40 also trade at nosebleed multiples.
Lofty valuations haven’t kept many of these stocks from making huge gains. Nvidia has more than tripled in the past year despite a consistently high price/sales ratio as revenue and earnings have blown past estimates. The same has been true for Lilly as investors ratchet up their expectations for its diet drugs for the rest of the decade.
But the risk of owning highfliers was illustrated by the recent drop in Snowflake, the hot data-aggregation software company that has had one of the loftiest valuations of any sizable public company since it went public in 2020. Its stock is down over 25% to $163 since late February, when it released mildly disappointing financial guidance for 2024. When a stock trades for almost 20 times sales and for well over 100 times earnings, it’s vulnerable even to a small miss.
Some of these companies don’t look ridiculously expensive on other multiples. Nvidia, for one, trades for 36 times projected earnings in its January 2025 fiscal year. The discrepancy between the two multiples is due to shortages of its chips used to power artificial-intelligence applications, a situation that helped Nvidia’s net margins — net income divided by sales — hit 56% in the latest quarter. That trounces Apple’s 25% and the average company in the S&P 500’s 10%, and is closer to Visa and Mastercard, quasi-monopolies that have consistently had some of the highest net margins in the S&P 500. Visa trades at 28 times forward earnings.
The issues for Nvidia are its revenue growth — Wall Street expects a slowdown to 20% in 2025 — and the sustainability of its margins, which have more than doubled in the past year. Those risks don’t seem to be reflected in the stock, which gained 10% during the past week to $900 after hitting another record high. The stock is up 80% this year and is valued at $2.3 trillion.
ARK Investment chief Cathie Wood warned about Nvidia this past week. In a letter posted on her firm’s website, she cited Nvidia’s guidance for “sequential” deceleration in growth, and falling lead times for its processing chips, to three to four months from eight to 11 months. “Without an explosion in software revenue to justify the overbuilding of GPU capacity, we would not be surprised to see a pause in spending, compounding a correction in excess inventories, particularly among the cloud customers that account for more than half of Nvidia’s data center sales,” she wrote.
Lilly, whose shares are up 150% in the past year to $765, is being valued on late 2020s earnings, given the growth potential for its GLP-1 diet drugs Mounjaro and Zepbound and its current inability to meet demand. Lilly is expected to earn about $12 a share this year, rising to $18 in 2025 and $30 a share in 2027, leaving it trading at about 25 projected 2027 earnings. Its reliance on diet drugs, however, makes it vulnerable to unexpected side effects from the medicines, other setbacks, and competitive threats.
Companies don’t need to be caught up in the AI or weight-loss hype to earn extreme valuations. Restaurants often carry above-market P/Es — McDonald’s trades for 23 times projected 2024 earnings — but Wingstop is in a class by itself. The chain is valued at nearly 20 times projected 2024 sales and over 100 times earnings. That’s a high valuation for a company that is expected to grow profits and revenue by about 25% in each of the next two years.
Costco Wholesale’s popularity with investors has never been higher, and its valuation shows it. The stock, at around $730, is up 50% in the past year and now trades for 45 times projected profits in its fiscal year ending in August. Costco is a great business, with a fanatically loyal customer base that renews memberships at a 90% annual rate and a “wide moat” due to rock-bottom prices. But the stock historically has traded at 35 times forward earnings. A P/E of 45 is a lot to pay for a company with low-double-digit projected earnings growth in the next two years. The stock fell 7% this past week after a mild earnings miss in its quarter that ended in mid-February. The company’s sales were up about 6% in the quarter and 5% in the first six months of its fiscal year — normally not the stuff of 45-multiple stocks.
Then there are oddball situations like WD-40, the lubricant maker. Its stock trades at around $250, or 50 times projected earnings in its fiscal year ending in August. This is high for a company that isn’t growing rapidly. Earnings this year are expected to be up about 7% to $5 a share, about equal to what it earned two years ago.
The award for most expensive stock, though, may go to Arm Holdings, the chip design company that went public in late 2023. It trades at 35 times sales based on projected revenue in its March 2025 fiscal year. The company has an attractive, capital-light chip design business and reported strong results for the December quarter. But its valuation is off the charts based both on sales and earnings, with the stock trading for 90 times projected earnings of $1.50 a share. And that earnings figure excludes sizable stock-based compensation. Arm’s thin float, at just 10% of its stock outstanding, may be contributing to the valuation.
Many of these companies, especially those in the tech sector, are even more expensive than they look because they continue to emphasize an earnings measure that excludes significant employee stock compensation. It is these earnings figures — and not those consistent with generally accepted accounting principles — that the analysts regularly cite, even though the companies do produce GAAP figures that properly include stock compensation.
Stock compensation is a real expense, as Berkshire Hathaway CEO Warren Buffett and others regularly point out. But tech companies continue to produce a blizzard of profit measures that exclude it, including adjusted net income, “free cash flow,” and adjusted earnings before interest, taxes, depreciation, and amortization.
A range of companies report these inflated, non-GAAP earnings measures, including Tesla, Nvidia, Salesforce, and Oracle. The gap between non-GAAP and GAAP earnings varies — it’s higher for software companies like Snowflake and lower for Nvidia. For Nvidia, the gap was around $1 a share last year, when its non-GAAP earnings were around $13 a share. Tesla had $3.12 a share in non-GAAP earnings last year, but profits including stock comp were $2.60 a share. Snowflake reported a $1 a share non-GAAP profit last year, but it was unprofitable on a GAAP basis.
It’s appropriate to make some adjustments to GAAP earnings, such as adding back noncash goodwill amortization — something Buffett supports — but not stock compensation, especially since most stock compensation is cash-like, restricted stock that is routinely monetized by employees. Not surprisingly, many tech companies are generous with stock compensation because it becomes a costless expense in non-GAAP earnings.
Tech bulls would acknowledge this issue but say that focusing on it would have caused investors to stay away from stocks like Amazon.com that have produced enormous gains. But not every tech company relies on non-GAAP earnings. Some, including Apple, Microsoft, Meta Platforms, and Alphabet, emphasize or only report GAAP earnings. This shows that accounting games aren’t needed to succeed in tech.
Investors should be careful about comparing the P/Es of Apple and other GAAP-focused companies to those that emphasize non-GAAP earnings, because the true P/Es of the non-GAAP companies are higher than they appear.
That’s a surefire way to look, well, silly.
Write to Andrew Bary at andrew.bary@barrons.com