When sharing prior Chart of the Week posts, I’ve looked at components of total return, value stocks relative to growth stocks and earnings expectations. This week’s chart focuses on the profitability and valuation of the broad U.S. equity market. I’ve chosen price-to-sales, a company’s market value divided by total revenues, because it is more difficult to manipulate, especially compared to earnings. The Russell 3000 Index is being utilized since it captures approximately 98% of the investable U.S. equity market.
Admittedly, I tend to be skeptical. I consider myself a contrarian value investor. So when I see high valuation metrics, I immediately take a step back, and doubt creeps into my brain. But in an effort to remain objective and state facts, let’s see what the data says.
The current price-to-sales ratio for the Russell 3000 Index is high at over 2.5x. In fact, it’s the highest data point on the chart above. However, we cannot ignore that the blue line, representing operating margin, is also at its highest point on the chart, which dates back to 1999. I’d argue that margins and multiples go hand-in-hand. Additionally, absolute revenues and operating profits for the components of the Russell 3000 Index are on track to post all-time highs for the 2021 calendar year. Generally speaking, this is good news.
The other side of the argument, which is that prices have outpaced economic fundamentals, can be made both on a total market and an individual security basis. U.S. equity market capitalization has outpaced corporate profits as a share of gross domestic product over the past year. The percentage of U.S. stocks trading over 10x price-to-sales, approximately 25%, is at its highest level since the tech bubble in 2000. Extremes can persist in the short term, but most of the time they tend to reverse course to the upside or downside.
Key Takeaway
Many of today’s equity market headlines caution about the valuation levels for stocks. And by many measures, valuation metrics appear to be at the high end of their historical ranges. However, it is also important to consider the underlying fundamentals: Revenue growth and margin expansion are increasing at high levels as well. I do not believe this is an easy puzzle to solve. Regardless of the economic backdrop, I will continue to focus my research on companies that I feel have the potential to grow revenues and profits, and increase their valuation multiples over many business cycles.
The material provided here is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management.
This material is for informational use only. The views expressed are those of the author, and do not necessarily reflect the views of Penn Mutual Asset Management. This material is not intended to be relied upon as a forecast, research or investment advice, and it is not a recommendation, offer or solicitation to buy or sell any securities or to adopt any investment strategy.
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