Stories to Watch: Tech Stock Arithmetic

Already-big stocks priced to grow more

I am having a hard time getting my arms around the valuations of the Magnificent 7 tech stocks: Apple, Amazon, Microsoft, Alphabet (Google), Nvidia, Tesla, and Meta (Facebook). Call them the M7 for short. Their stock prices are high relative to current earnings, which means they are being treated as growth stocks. But they are already huge relative to the U.S. economy. How can it be that they are already large and yet expected to grow rapidly going forward?

In December of 2001, Warren Buffett and Carol Loomis introduced what became known as the Buffett Indicator for stock prices. They took the ratio of the market capitalization of all publicly traded stocks to GDP. When this ratio is low, say 0.8, then stocks are cheap. When the ratio is high, say 2.0, stocks are expensive. Note that market capitalization is based on the stream of earnings expected in the indefinite future, and GDP only measures the size of the economy this year. So we have no direct intuition of what the Buffett Indicator ought to be. We just have some past history.

Anyway, I recently calculated the M7 Buffett Indicator (M7BI), using the M7 instead of the entire set of U.S. public companies. As of the end of August, the M7 had a collective market capitalization of $11 trillion. I compared this to second quarter current-dollar GDP of $26 trillion at an annual rate. So the M7BI 11/26, or 0.4, which seems pretty high for just seven companies.

Next, watch me perform some algebra, starting with the definition of the M7BI. Let P be the market cap of the M7 and let E be the total profits of the M7. Then

M7BI = P/GDP = (P/E)(E/GDP).

It seems that E is about $285 billion, which makes E/GDP about .011, which makes P/E close to 40.

Let R be total corporate profits in the national income accounts. Let S be the fraction of total domestic corporate profits going to the M7. We then have

(E/GDP) = (S)(R/GDP)

In the national income accounts these days, R/GDP is about 0.1, meaning that corporate profits are about 10 percent of the total value of goods and services produced. This is actually high relative to historical averages. S is also about 0.1, which gets you to E/GDP = .011

<s>I have not computed S (does somebody feel like doing that?), but I would wager that it should not exceed .04</s>

[essay edited 9/4]

E/GDP includes profits earned domestically and profits earned abroad. But are earnings from abroad likely to grow faster than domestic earnings? These companies already have large overseas sales. And they face slow population growth in Europe and Asia and competition in many local markets.

My quarrel with the people investing in tech stocks is that I do not think that there is enough room for growth to justify such a P/E ratio close to 40. You can make a case for Nvidia and Tesla having room to grow a lot, but Apple, Amazon, and Google are mature companies in mature industries. There is only so much of the economy that can be spent on Internet ads, smart phones, delivery of Web orders, cloud computing, high-end chips, and niche cars. Moreover, the profit margins in most of these areas are more likely to shrink than expand over the next several years.

I would be surprised if five years from now the total market cap of the M7 has kept up with inflation. I would not be surprised if five years from now the total market cap of the M7, adjusted for inflation, is less than 70 percent of what it is now.