Are Large-Cap Stock Bubbles About to Start Bursting?

The history of the stock market is filled with bubbles that inflate and burst. In a free-market economy, this phenomenon is fairly common. Most recently, the U.S. housing bubble of the early 2000's wreaked havoc on the economy when it started to burst around eight years ago. In hindsight, these bubbles often seem so obvious that it is mind-boggling that nobody seems to notice them forming in real time. Of course, the handful of people who do see the bubbles forming can make some major money when they burst. Today I'd like to take a look at three large-cap stocks that might currently be experiencing bubbles in share price: Amazon.com (AMZN 1.30%), Adobe Systems (ADBE 1.29%), and Netflix (NFLX 4.17%).

Exceptional circumstances
Long before the housing bubble, way back in the prior millennium, enthusiasm for the monetary potential of the Internet laid the groundwork for the dot-com bubble. One key element of most bubbles is the belief in the exceptionalism of the circumstances. In the late 1990's, investors believed that the Internet would become such a cash cow that they flocked into any stock with a "dot-com" attached to its name. At the time, investors completely disregarded traditional stock valuation metrics such as the price-to-earnings ratio, or P/E. The belief was that the connectivity and access to information that the Internet would provide was going to lead to an era of economic opportunity that the world had never seen before.

The Internet has certainly provided unprecedented financial opportunity. However, the prominent belief at the time seemed to be, "It doesn't matter how expensive stocks are because the Internet is the exception to the lessons that history has taught us about stock valuation." This belief in exceptionalism is always a dangerous belief to hold.

The ghosts of bubbles past
In March of 2000, Jeremy Siegel wrote an article for the Wall Street Journal entitled "Big-Cap Tech Stocks Are a Sucker Bet." In the article, Siegel challenged the belief that Internet stocks were the exception to the rules of the market by noting that "many of today's investors are unfazed by history -- and by the failure of any large-cap stock ever to justify, by its subsequent record, a P/E ratio anywhere near 100."

Siegel focused on companies with extremely high P/E ratios at the time, such as Nortel Networks (1999 P/E of 105.6), Cisco (1999 P/E of 148.4), and Yahoo! (1999 P/E of 119.0). Nortel filed for bankruptcy in 2009. Cisco and Yahoo! survived the burst of the bubble, but the stocks each took major hits. In January 2000, Yahoo! shares reached $118.75, but subsequently plunged 93% to $8.11 by September 2001. In March 2000, Cisco briefly became the world's largest company by reaching a market cap of $555.4 billion. 

By 2001, Cisco's market cap was only $151 billion. Now, nearly 14 years later, Cisco's market cap is $124.6 billion.

This time it's different... right?
Shareholders of Netflix, Adobe, and/or Amazon are probably well aware of the multiples at which these stocks currently trade. Defenders of these companies argue that high growth rates justify these otherwise ridiculous P/E ratios. There's no arguing that these three companies are rapidly growing, but so was Cisco in 2000. One of Siegel's main points was that once a company reaches large-cap size, it becomes increasingly difficult for it to grow at such a high rate. However, assuming that these companies actually grow their earnings at their current projected five-year growth rates (according to finviz.com), what will their P/E ratios look like in five years?

The answer: not great. However, here's the kicker: these projected P/E ratios assume a 0% change in share price over the next five years. Siegel made similar projections for the companies mentioned in his article and assumed investors were expecting 15% annual returns from these types of high-growth stocks. Assuming 15% annual returns in share price produces the following projected P/E ratios five years from now:

Again, those are some pretty ugly ratios.

Time to panic?
Just because a stock is trading at a high P/E ratio doesn't necessarily mean that a crash is imminent. For example, Netflix's P/E ratio has been over 100 since late 2012, and the share price has risen steadily since that time. Also, I'm not suggesting that Netflix, Amazon, and Adobe are terrible companies, no more than Cisco and Yahoo! were terrible companies back in 2000.

However, if you are a shareholder of these three companies or any other large-cap stock with a P/E over 100, you need to ask yourself these two questions: Is the astronomically high growth rate that is required to justify the current share price a reasonable growth rate to expect for such a large company? Is my company truly the exception to Jeremy Siegel's observation that no large-cap companies have ever justified this high of a multiple?