On Aug. 2, 2018, something happened that had never before occurred on an American stock exchange: Apple's (NASDAQ:AAPL) total value surpassed the $1 trillion valuation mark. And just one month later, e-commerce giant Amazon (NASDAQ:AMZN) crossed the same threshold.
Both stocks have sunk since then, and neither has a market capitalization of more than $1 trillion anymore. Today, the $1 trillion club has no members, which raises the question: Which company will be next to breach the $1 trillion mark? Of course, Apple and Amazon could shoot back up, but there are three other companies that seem quite capable of hitting $1 trillion -- maybe even in 2019.
You probably know of software giant Microsoft (NASDAQ:MSFT) and Google parent Alphabet (NASDAQ:GOOGL) (NASDAQ:GOOG). And you may be familiar with Berkshire Hathaway (NYSE:BRK-A) (NYSE:BRK-B), the company run by celebrated investor Warren Buffett.
|Company||What It Does||Current Market Cap|
|Microsoft||Maker of Windows and OfficeSuite||$880 billion|
|Alphabet||Parent company of Google||$835 billion|
|Berkshire Hathaway||Energy and insurance conglomerate||$505 billion|
But before you take up a position in these behemoths, we'll cover several important caveats so you know what you're buying into.
Why is the $1 trillion mark so important?
First, let's get some definitions out of the way. Market capitalization -- or "market cap" -- represents the total value of a company. If you wanted to buy the entire thing, the market cap is what you'd have to pay. While most finance websites calculate it for you, market cap is simply the number of shares outstanding multiplied by the price per share.
While there's no industry-standard definition, stocks generally fall into one of five categories based on size:
- Micro caps: market cap of less than $300 million
- Small caps: $300 million to $2 billion
- Mid caps: $2 billion to $10 billion
- Large caps: $10 billion to $300 billion
- Mega caps: $300 billion-plus
There's nothing inherently special or noteworthy about achieving a $1 trillion valuation. It's an arbitrary number, more meaningful to investors than the numbers before it because it's a psychological barrier being crossed. Indeed, it's a marvel to see that many commas and zeroes: $1,000,000,000,000!
But entering the $1 trillion club doesn't convey any special benefits to the company or any of its owners (that's you, the shareholder). Instead, it's more a badge of honor.
What are the advantages of owning a $1 trillion stock?
That being said, when a company grows big enough to garner such a valuation, that's evidence it's doing something right -- namely, that it's offering a product or service that's become highly sought after, and that it's doing so profitably. Apple's march to $1 trillion was possible because of the iPod, iMac, iTunes, iPad, and -- above all else -- the iPhone. And to see how dominant Amazon has become in e-commerce, all you have to do is look at the porches of your neighbors.
So owning a piece of a $1 trillion company means you have stock in a market leader. It's true that past performance doesn't guarantee future returns. But it's also true that achieving dominance in an industry -- and maintaining it long enough to reach a $1 trillion valuation -- is evidence of a highly competent organization.
Often, but not always, massive companies offer a reliable dividend as well. And that would pay you quarterly just for owning a piece of the company.
What are the disadvantages of owning a $1 trillion stock?
But there are downsides to owning shares of such a large company, too. None more so than this: Once it's achieved an enormous scale, a company usually finds it difficult to provide similarly amazing returns moving forward.
Shareholders who bought Amazon during the 2008 financial crisis have experienced returns of over 4,600%: A $10,000 investment has become nearly half a million dollars. Yet there's simply no way for anyone buying the stock today to realize such returns. If Amazon's share price grew another 4,600%, its market cap would be around $38 trillion -- according to United Nations figures, that's more than the combined gross domestic product of the United States, China, and Japan.
Also, larger organizations are inherently more difficult to manage. With operations spread across multiple industries, these companies risk losing market share to smaller and more nimble start-ups. And as the leadership in a trillion-dollar behemoth turns over, there's no guarantee the next generation of management will execute as well as their predecessors.
For evidence, look no further than General Electric. In 2000, the company's market cap hovered near $600 billion. One year later, after the dot-com bubble burst, it was the world's most valuable company. But as it set up operations in multiple industries -- manufacturing, renewable energy, aviation, healthcare, finance -- the company lost its focus. Today, GE has lost 87% of its value from those early-2000s highs, and the situation for current shareholders doesn't look pretty.
That's why you can't invest in a company just because of its size. You need to look under the hood and get a full understanding of why you're buying it -- and what would make you want to sell it.
How to evaluate candidates for the $1 trillion club
Having said that, let's look at how we'll evaluate our $1 trillion candidates. For each company, you'll see a number of metrics, including:
- Net cash position: This takes all of the cash and investments a company has, and subtracts long-term debt. This is important because if a company hits hard economic times, it needs liquid cash to survive. If the cash position is large enough, a strong company can actually benefit from a downturn by buying back its own stock, or buying out rivals that are suffering.
- Three-year sales growth: The percentage by which a business has grown per year over the last three years. Even large companies need to keep growing sales in order to reach a $1 trillion valuation.
- Three-year earnings growth: You'll need to monitor earnings growth too. Not all sales become profit, so subtract all the costs of running the business, from workers' salaries to taxes. Earnings per share (EPS) is derived by taking the total profit and dividing by the number of outstanding shares. We can then measure EPS growth over three years.
- Price-to-earnings (P/E) ratio: This is a company's share price divided by its EPS, usually over the past ("trailing") 12 months. To put this ratio in perspective, the overall P/E of the S&P 500, which represents the broader market, is around 20 at this writing.
- Price-to-free-cash-flow (P/FCF) ratio: It's important to measure P/FCF, because EPS includes accounting measures that don't reflect what a company actually brings in over the course of a year. Free cash flow is all of the money a company has put in its pocket from operations over the past year, minus capital expenditures.
- Price-to-earnings-growth (PEG) ratio: This metric divides P/E by the percentage that earnings are expected to grow annually over the next five years. If a company has a P/E of 20, and is expected to grow earnings by 10% per year for the next five years, it would have a PEG of 2.0. Generally, a PEG of 1.0 means a company is fairly valued while a PEG below 1.0 means it might be "cheaper" than you'd expect, and PEG higher than 1.0 means it could be considered "expensive."
There's also a more difficult thing to measure: a company's sustainable competitive advantages -- also known as its moat. Generally speaking, there are four different types of moats a company can enjoy:
- Network effects: With each additional user, a company's offering becomes more valuable. Facebook is a textbook example: With each additional user, nonmembers gain incentive to join the service, as it becomes the place where all of their friends are online.
- High switching costs: It can be painful to switch away from a company -- because of the cost, the threat of losing business, or the headaches involved. The simplest example might be your bank account: There might be plenty of other banks offering better products, but switching banks can be such a hassle that most of us just don't bother.
- Low-cost production: This is when a company can offer something of equal value to customers for less than the competition can. This is a cornerstone of Amazon's moat. Because the company has over 130 fulfillment centers throughout the United States, it can afford to offer free two-day shipping with Prime memberships at a lower internal cost than the competition.
- Intangible assets: This includes the value of a company's brand (think of how much more people pay for Apple products), its patents (for tech and drug companies), or even its government-protected monopoly (for energy producers and other utilities).
When you put all the pieces together, you should have a better understanding of each company, and what it would take to achieve the elusive $1 trillion valuation.
Many of us were introduced to Microsoft via the Windows operating system for desktop computers, and OfficeSuite applications including Word, Excel, and PowerPoint. Those two pieces of the company still remain, but there have been important changes over the last 15 years.
Let's look at some metrics for Microsoft:
|Net Cash||3-Year Sales Growth||3-Year EPS Growth||P/E||P/FCF||PEG|
Microsoft has a massive cash balance on the books. In the past, it has used that cash for some questionable acquisitions, but its most recent big splash -- buying LinkedIn -- has actually worked out quite well.
While sales growth clocked in at a modest 5.7%, earnings have grown at more than double that rate because the company transitioned, under CEO Satya Nadella, to a software-as-a-service (SaaS) model that creates greater profits.
Office 365, Windows, and cloud services account for about two-thirds of its revenue. Nadella made tough decisions to vastly improve the first two, while spearheading cloud hosting with Azure.
As with most SaaS companies, Microsoft benefits from both network effects and high switching costs. Companies that set up their businesses on Azure -- or that depend on Word, Excel, and Outlook email -- don't want to switch providers without a compelling reason. Cloud hosting on Azure allows Microsoft to collect more data about its customers, which it can then leverage to create better solutions.
I believe there's about a 30% chance Microsoft will be the next company to cross the $1 trillion threshold for the first time. In fact, with a market cap around $880 million, it needs a bump in share price of less than 14% to get there.
A combination of growth in earnings (which are expected to grow 7% over the next year) and an increase in the P/E (reflecting higher investor optimism) would do the trick. In fact, in mid-2018, Microsoft's (non-GAAP) P/E was 26.5. If it produces the earnings expected next year and garners that P/E, the market cap will be around $915 billion -- within spitting distance of $1 trillion.
Alphabet is better known as the parent company of Google. The company decided to create a new name to highlight its "Other Bets" outside of Google (which was its alpha bet...get it?) -- moonshot projects with enormous potential.
|Net Cash||3-Year Sales Growth||3-Year EPS Growth||P/E||P/FCF||PEG|
Don't fret over the negative earnings growth, which was largely the result of a one-time antitrust fine from the European Union. Without that fine, earnings growth would clock in at just over 40%.
Alphabet is a unique animal, as it has one of the biggest cash piles in the world. Although it's a colossal gorilla in the advertising industry, it has still managed to grow sales by nearly 20%, which is rare for such large companies.
The key to understanding Alphabet is that it gets more than 85% of its revenue from advertising. Google has eight different tools with more than 1 billion active users each: Search, Maps, Chrome, Android, YouTube, Google Drive, Google Play Store, and Gmail. Most of those are offered up for free, but in turn, Google collects data on users that it can sell to advertisers.
Therein lies the real secret of Alphabet's competitive advantage: low-cost production of data. Relatively speaking, it doesn't cost Google much to maintain any of those eight tools once they're built. But each additional user gives the company more data, which translates into higher advertising revenue. As long as all these products remain popular, it's impossible for any competitor (aside from, perhaps, Facebook) to challenge Alphabet's data game.
The company is also embarking on what it calls "moonshot" projects: High-impact initiatives that aim to fundamentally change life for humans for the better. Current projects include the Waymo self-driving car service, cybersecurity outfit Chronicle, and remote-Internet provider Loon. While Alphabet's "Other Bets" have cumulatively been a money-losing venture so far, all it would take is one bet to "hit it big" to more than offset those losses and create meaningful sales -- and profit -- for the company.
Alphabet probably has the best shot at being the next company to cross the $1 trillion mark. It would take only a 20% gain from today's prices to hit that target. Earnings are expected to be flat next year as the company invests in future initiatives, but an increase in P/E -- perhaps nudged along by Waymo, as it starts meaningfully contributing to the income statement -- could put the company over the top. I'd handicap Alphabet's chances as around 40%.
Over time, he's used it as a vehicle to invest in and acquire a wide-ranging network of businesses, including outright ownership of GEICO (insurance), Burlington Northern Santa Fe (railway), Dairy Queen (ice cream and fast food), Duracell (batteries), and Fruit of the Loom (clothing).
Buffett focuses on value stocks -- companies that produce reliable sales streams and are undervalued by the market. So he tends to avoid highfliers and technology companies, though that's changed somewhat in recent years. It also means that most of his investments seem pretty boring on the surface, but end up producing massive wealth over time.
Consider this: if you invested $1,000 in the S&P 500 in 1965, it would have grown to about $156,000 by 2018 -- including dividends. If, however, you had put that same $1,000 into Berkshire Hathaway stock, it would have grown to over $24 million in the same time frame. That's the power of Buffett's golden management (coupled with consistent compounding).
Let's take a look at how all of those businesses are growing, and how the market is valuing them today:
|Net Cash||3-Year Sales Growth||3-Year EPS Growth||P/E||P/FCF||PEG|
Cash is not a problem for Berkshire. In fact, during the financial crisis of 2008, Berkshire Hathaway's cash position was so strong that it became a lender of choice for distressed businesses. That financial fortitude gave the company favorable terms (read: it got a lot of money) that others could only dream of.
Moderate sales growth is not surprising, but like Microsoft, Berkshire is showing it can grow earnings at almost twice the rate of sales growth. And with a P/E of 14, Berkshire is trading at a pretty significant discount to the rest of the market.
When it comes to competitive advantages, Berkshire has a number of them, depending on the subsidiary. Railroads, energy, and utility companies are all protected by high barriers to entry, thanks to government regulations; the average entrepreneur can't successfully start a new railroad or nuclear energy company because it takes an enormous amount of financial and political capital. Those subsidiaries accounted for 39% of non-investment income in 2018.
The insurance business has high switching costs and benefits from strong brand awareness -- everyone knows the GEICO gecko. Insurance combined with financial products and manufacturing makes up Berkshire's other 60% of revenue.
Let's not ignore also the massive income produced by Berkshire's investments. Furthermore, the companies Berkshire owns stock in all have their own impressive moats. For instance, Apple is Berkshire Hathaway's largest holding; Apple has the strongest brand in the world (as measured by Forbes), and because all of its products are synced together, it benefits from high switching costs. The next two biggest holdings -- Bank of America and Wells Fargo -- are also protected by high switching costs, because changing banks is a headache no one wants to deal with.
I'm less confident that Berkshire will cross the $1 trillion mark anytime soon. Its market cap is barely over $500 billion, meaning the company would have to double in value. Of course, nothing is impossible with Buffett, but getting to that magic number is likely to take longer than for Microsoft and Alphabet. If there were a significant and long-lasting market downturn -- enough to hurt the share prices of the tech companies -- it'd be more possible for Berkshire to beat them to the finish line. In the end, I'd peg Berkshire's chances of being the next to cross $1 trillion at 10%.
My money is on...
You might have noticed that adding my percentages together doesn't total 100%. That's because I think there's about a 20% chance that the next company to reach $1 trillion won't be any of these three. After all, in 2001 Apple was worth about the same as TripAdvisor is today; anyone who said back then that Apple would reach $1 trillion would have been laughed out of the room.
But my money is firmly on the company that I believe has the best shot: Alphabet. Shares of Google's parent account for over 12% of my family's real-life holdings, and I believe it has the chance to go far beyond $1 trillion in the decade to come.