There's been a lot of talk about the "Magnificent Seven" stocks recently. These large, competitively advantaged tech platforms have vastly outperformed the market over the past decade, and they also seem like great bets to benefit from the artificial intelligence revolution, too.
But their strong recent run has led many to believe these stocks are either overpriced or fairly priced relative to the rest of the market. On the other hand, many have been saying that for years, only to see these tech giants surpass earnings expectations.
How to balance their relatively high market valuations with their above-average growth prospects? One valuation metric touted by one of the most famous mutual fund managers of all time may hold the secret.
NASDAQ: NVDA
Key Data Points
The PEG ratio
The PEG ratio, or price-to-earnings-to-growth metric, was first developed in 1969 by Mario Farina and later popularized by Peter Lynch, portfolio manager for the Fidelity Magellan Fund in the 1980s.
To calculate the PEG ratio, an investor should divide a company's P/E ratio by its expected earnings growth rate. In general, stocks may have a PEG ratio between 1 and 2, with stocks with PEGs under 1 considered undervalued, and stocks above 2 considered overvalued.
A PEG ratio is an imperfect measure, to be sure, as some investors may use either the trailing or forward P/E ratio, and others use different lengths of time to calculate the long-term earnings growth numbers.
One standard type of PEG ratio is to look at the P/E ratio based on current year expected earnings, and the outlook for the next five years' earnings growth.
Magnificent PEG Ratios
Here's how the PEG ratios the Magnificent Seven stocks shake out.
|
Company |
PEG Ratio |
|---|---|
|
Meta Platforms (META 3.83%) |
1.10 |
|
Nvidia (NVDA 1.56%) |
1.36 |
|
1.49 | |
|
Tesla (TSLA 0.96%) |
1.93 |
|
Microsoft (MSFT 1.57%) |
2.11 |
|
Apple (AAPL 2.15%) |
2.12 |
|
Amazon (AMZN 0.87%) |
2.36 |
Data source: Yahoo! Finance.
There are a few expected results here, but also a few surprises. First, it's not surprising to see both Meta and Alphabet among the cheapest of these stocks. These two generally trade at discounts to other "disruptive" tech names, perhaps because of their already being large, "mature" companies. Moreover, many investors give less credit to revenue and profits that come from advertising, as ad revenue is thought to be economically sensitive and perhaps flighty.
Still, that has been the case for years, and both Alphabet and Meta have generally been able to defy skeptics and continue solid growth over the long term as ad dollars continue to flow to digital ads from traditional advertisements.
In addition, Alphabet has lots of cash on its balance sheet and generates significant losses from its "Other Bets" segment, increasing its P/E ratio relative to its core business and making it look more expensive. And since it's really hard to know whether some of Alphabet's moonshot projects will pay off, analysts probably aren't forecasting any contribution from these loss-making but forward-thinking businesses, perhaps underrating Alphabet's earnings growth prospects even further.
And of course, besides a reasonable valuation, Meta's new dividend is a good sign of confidence management has in the sustainability of its earnings. Thus, both of these stocks may be worth looking at if contemplating allocating to Magnificent Seven stocks today.
One big surprise here is Nvidia, which actually comes out as the second cheapest stock based on this measure. That's despite having the highest trailing P/E ratio at 73.5. That is, of course, because analysts are forecasting robust growth for Nvidia based on its lead in GPUs that currently dominate the artificial intelligence market. From the looks of it, it appears analysts believe that advantage will continue, and that the AI revolution will deliver sustainable high growth for Nvidia over the immediate term.
Image source: Getty Images.
Are the bottom four worth considering?
Tesla, Apple, Microsoft, and Amazon are all near 2 or above in terms of their PEG ratios, making them generally unattractive on this metric.
However, that doesn't necessarily mean one should avoid these stocks. Remember, the PEG ratio is just one indication, based on future earnings growth that is somewhat unknowable.
Moreover, each of these companies have slightly different reasons for their high PEG ratios. Both Microsoft and Apple are generally given high valuations, not necessarily because of growth, but rather because of the stability of their businesses and the confidence that earnings will generally remain intact for a long time. Apple obviously has among the best consumer franchises in the world with the iPhone, making it not only a tech stock but more of a consumer staple. And consumer staples stocks generally trade at higher valuations despite lower growth, because of their perceived "safety" in good economic environments and bad.
Microsoft is also regarded as a very safe stock, because of its dominance of not one but several high-profit businesses, including the Windows operating system, the Office enterprise software suite, and its Azure cloud computing platform. Add in its exclusive arrangement with OpenAI, and it's perhaps no wonder Microsoft is given a high valuation that may be deserved.
On the other hand, the high PEGs for Amazon and Tesla probably have to do with their high multiples today and the substantial uncertainty to their future earnings.
Amazon has typically spent all or most of its profit on future innovation, so its bottom line is incredibly difficult to project, even if the company generally does well. It's likely that Wall Street analysts aren't projecting much profit inflection, as is the case for Alphabet's "other bets," since Amazon hasn't really ever harvested profit in a significant way.
Meanwhile, Tesla is a pioneer in the emerging electric vehicle market, which has high growth expectations over the long term. However, that market has slowed in recent months amid high interest rates, and Tesla's earnings are actually currently declining as it cuts prices.
The combination of high long-term growth expectations in the face of a likely earnings decline this year means Tesla is quite risky. In fact, I would personally own Amazon over Tesla, despite the slightly higher PEG, since I think Amazon is more likely to see profit inflect upward relative to current analyst expectations than Tesla.
Don't just use the PEG
The PEG ratio can be useful in offering a very quick snapshot of a company's valuation relative to its growth. However, one factor the PEG ratio doesn't capture very well is a business' safety compared with other stocks. P/E ratios are a reflection of both growth expectations and risk, but risk is a very squishy and difficult concept to quantify.
Moreover, the greatest stock gains usually come from businesses that wildly outperform expectations, so using a metric that merely reflects expectations is also a limiting factor. That's why the PEG ratio is best used for companies with stable earnings growth, and not a bottom line that may bounce around year to year such as Amazon or Tesla.
Overall, the PEG ratio is just one shortcut for investors. But remember, a company's intrinsic value is always the present value of future cash flows. If you come across a company that looks cheap based on a PEG ratio, see if you can dig deeper and map out what you think cash flow can do over the next decade, as well as the probability that your projected scenario will unfold.
While the PEG ratio is a useful shortcut, remember that it's more a starting point than a destination.
