Are technology stocks overvalued?
Technology companies are the most undervalued stocks, according to a recent report by research firm Morningstar. In the technology sector, about half of all stocks were overvalued based on Morningstar’s price/earnings comparison.
“The tech boom is over” might be a common refrain from stock investors and analysts, but there are still plenty of reasons why these stocks are still relatively cheap. In this case, technicals were the main reason why the tech sector was so undervalued.
Morningstar’s price/earnings ratio comparison shows that S&P 500 technology stocks were trading at more than twice their trailing earnings and about 60% higher than peers in mid-2019. In fact, the largest tech names like Amazon, Facebook (FB), Alphabet (GOOGL) and Microsoft (MSFT) traded at just 10 times earnings or less than their five-year average earnings growth rate of 8.5%. The stock market has been extremely volatile over the past few years due to both: 1) geopolitical events and 2) debt levels rising to unsustainable levels. However, these conditions have started to resolve themselves as we approach end-of-the-year 2019 and we’re now on track for another year of very strong “growth.”
Given this recent history of high volatility in stock markets that is being relieved by a very strong business environment, shares in tech companies remain attractive relative to peers’ earnings expectations. This is especially true for those who might be tempted to cut their losses on investments in digital media because they don’t see obvious signs of future growth in either content or advertising sales — both of which have suffered during the latest bear market phase we’ve experienced so far. Here are some reasons why this situation continues to be attractive:
1.) High growth rates;
2.) Very low debt levels;
3.) Low cost base;
4.) Small ownership; and
5.) Valuation multiples that suggest meaningful upside without worrying about yields or inflation over time.
The communication services index
The communications services index tracked 16,500 companies, from Apple up to Tata Communications . The monthly returns of the index, which measured the performance of companies whose shares are traded on major US exchange markets, were also above normal in January and February. The average (median) return was 11.3 percent for the full year.
For a three-month period ending on December 31st, 2018 alone, the communications services index recovered all but 8 percent of its losses and returned 3 percent higher than its annual level at the beginning of the year. This figure is much better than the 10-year median return of -6.5 percent.
“We have seen this before,” said David Wessel , an equity analyst at Wells Fargo Securities . “The market has gotten too high in some sectors and this is another example.”
He cited a statistic from UBS , which shows that five out of every six stocks that make up the OMX50 Index — a benchmark for about half of all European stock exchanges — have increased their valuation during January to March this year.
“We expect that there will be some correction in valuations again,” said Wessel . “Investors are getting nervous about these kind of things.”
Morningstar’s price/fair value estimate readings
The communication services index finished the year at more than 21 times earnings, compared with a 10-year average of 18. Using Morningstar’s price/fair value estimate readings, tech stocks were also well into overvalued territory for most of 2021. The telecom, cable and satellite services sector was the worst performer in this category, down about 9% from 2018 despite a surprisingly robust performance in the technology sector.
The performance of the communication services index has been historically high for most years since inception. However, we believe that it is overvalued by several factors:
• The fact that its top four sectors are not all technology companies (which makes sense if you look at their business models)
• The fact that it is not as diversified as it could be (with very few in telecom or media)
• The fact that its top four sectors are not all tech companies (which makes sense if you look at their business models)
This article shows how Morningstar’s analyst consensus prices for each sector have changed over time and how the industry averages have changed over time. In our analysis, we looked at both what analysts expect to earn and what they are actually earning today. We then used this information to calculate average growth rates over five years based on historical data. We then compared these with Morningstar’s own estimates of growth rates for each sector to see how accurate they were. The findings show that the industry averages tend to be pretty good predictors of future growth rates:
For instance: If an analyst expected GDP growth to increase 5% annually from 2012 through 2019, he would be “within” his forecast range if he expected GDP growth to increase 5% annually from 2012 through 2019—meaning that he was within range if his estimate was within 2 percentage points of reality or more . Our estimate also showed that an analyst who estimated GDP growth would actually earn less than he did in 2016–2017 ($4,699 vs $4,639)—a difference of $35k–$37k at a 5% rate change—and an analyst who estimated GDP growth would actually earn less than his assumption is today ($5100 vs $5201)—a difference of $20k–$22k at a 5% rate change—when measured against his own estimates in 2016–2017 ($3171 vs $3183). You can see these graphs on our ‘rate change’ page where you can find out more details on how we calculated our estimates.
One
Overvalued technology stocks
Since the passage of the JOBS Act in 2011, the amount of funding available to tech firms has exploded, with more than $70 billion being raised in the last six months alone. But while this has brought enormous amounts of money to startups and large companies alike, it has not led to great returns for investors. Technology stocks have been trading at a discount to other stocks for years:
The argument against tech stocks is simple: they are bubble-prone. In 2017, most tech stocks traded at discounts to their price-to-earnings (PE) ratios. Even as recently as June 2017, it was still possible to buy tech stocks for less than their average PE ratio. And that discount continues today:
It isn’t that technology is overvalued — just that bubbles happen and there’s no reason we shouldn’t learn from them. But what happens when you ride a bubble? When tech stocks were trading on discounts back in 2011, it was clear not just that they were overvalued, but also that they were going to crash:
Technology shares have been trading at discounts for some time now, but a lot is riding on whether or not we get another stockmarket crash next year (the S&P 500 is down 26% from its all-time high)…
If you are wondering why you haven’t seen a market crash yet (as I was), here’s one reason: when people think about “stock market crashes,” they tend to think about Wall Street and financial firms. But there’s another way to think about them…
The result of this disconnect between investors’ expectations and reality has been a stock market that’s hit new lows every couple of years since the start of last year…
Stocks may be expensive relative to their fundamentals — but then again, maybe not! What if we replaced those fundamentals with something else? What if we figured out how much money an investment actually cost us? What if we got rid of our assumptions about what kind of company making an investment should look like?
In other words… what if we looked at investments as having costs rather than doing them right? We might finally find out how much money investors are willing to pay for something… Or how much they’re willing to risk by investing in anything at all! Or what happens when you turn up the heat on somebody who thinks it’s too hot outside…
Conclusion: Are technology stocks overvalued?
Tech stocks are the epitome of overvaluedness. They are among the most expensive of all asset classes, as measured by their combined beta, price to earnings and price/sales ratios.
This is not to say that tech stocks aren’t fundamentally sound—they are. We own a few of them in our portfolio, but they all have significant downside risk (as reflected in their beta and price-to-earnings) from secular trends that we believe will continue in the years ahead. This, in turn, means that we have limited ability to profit from new advances in technology; we can only make small to moderate gains from them (at best). This is especially true for companies whose businesses have already been commoditized since many investors have already invested heavily in these technologies.
In addition to being a big overvaluation risk, there is some evidence to suggest that technology stocks may be overvalued from an investor point of view as well. While many tech stocks have made solid gains this year—and the stock market has surged on the back of corporate earnings growth—the largest percentage gainers are often high-growth companies whose valuations are driven by their strong growth trajectory rather than fundamentals (see our Tech Scorecard).
Our assessment is based on two sources: first, a recent re-analysis of Amazon’s (AMZN) financials; second, a contrarian analysis of Apple’s (AAPL) financials done by two analysts at Morningstar using Morningstar’s valuation model with different levels of growth assumptions.
We found three significant points:
Amazons’ revenue growth far outpaces its reported earnings growth . If we assume Amazon continues at this pace through 2019 (which seems likely given the company’s large cash reserves), annual earnings would increase by just under 50%, compared with an expected 26% growth rate for EPS for 2019 and 20% for 2020; Amazon would rank 19th out of 25 U.S.-listed tech stocks based on total returns through 2017 and 20th out of 23 U.S.-listed tech stocks based on total returns through 2018 . If you take away double-digit free cash flow growth (which seems unlikely because it would lock up capital), Amazon ends up with significantly lower EPS growth than expected compared with the rest of its peers .
Apple’s revenue growth outpaces its reported earnings per share , but not its reported PEG ratio and non-GAAP net income ; unlike Amazon , Apple isn’t