The ongoing US stock market rally is presenting a major question to investors; do valuations still matter? For one, the equities market seems to be disconnected from reality and traditional valuation metrics like price-to-earnings (PE), EV to EBITDA, and price-to-sales (P/S). 

This issue has become more common now that the world has seven companies with a market cap of over $1 trillion. These companies, including Saudi Arabia’s Aramco, have a combined valuation of over $15 trillion, which is substantial considering that the world has a GDP of over $95 trillion.

There are different approaches to look at company valuations. One of the most popular is the one known as the Warren Buffett indicator, which looks at the market cap of all American companies and compares it with the US GDP. The figure stands at 179.5%, meaning that stocks are significantly overvalued.

Narrowing down, we can also look at the PE multiples of American stocks. Data shows that the PE ratio of the S&P 500 index stands at over 23 and is lower than last year’s high of over 25. The tech-heavy Nasdaq 100 index has a PE ratio of 25.

These numbers mean that investors are paying a premium for stocks. This is partly because these investors have no alternatives to store their money now that the bond market is bracing for a $54 trillion black swan event. 

Most importantly, American companies have demonstrated their ability to continue growing. For example, a company like Tesla was making less than $10 billion in annual revenue a few years ago. In 2023, it neared $100 billion.

A look at some of the top companies shows that they are priced beyond imagination. For example, Nvidia is now valued at over $1.73 trillion as its stock jumped by 213% in the past 12 months. This means that the company’s valuation will take a few months to get to a $2 trillion valuation. It trades at a forward PE ratio of 56.

Other highly-valued companies are Super Micro Computer (SMCI), Shopify (SHOP), and CrowdStrike (CRWD). All these companies have a forward PE of over 25, meaning that investors anticipate strong growth in the future. 

Let’s look at CrowdStrike, a company with a forward PE of 107. This is a company whose revenue is expected to rise to $3.9 billion this year having a valuation of over $76 billion. 

Warren Buffett indicator

Value investors who aim to invest in undervalued companies have underperformed the market in the past few decades. Just look at Warren Buffett’s performance, which has trailed that of the S&P 500. Also, popular value ETFs like MOAT, COWZ, and SCHD have all underperformed growth ones like QQQ and QQQM.

The main reason why valuations seem not to value is that the market has become momentum-based now that computers are doing most of the trading. Think of what David Einhorn of Greenlight Capital said recently.

“I view the markets as fundamentally broken. Passive investors have no opinion about value. They’re going to assume everybody else has done the work.”

The reality is that a big part of the market is being controlled by algorithms, which explains why quant hedge funds are beating their counterparts. This means that investment decisions are not being made by value investors who have studied valuations well. A well-known analyst told me:

“Computers don’t do valuation analysis. They don’t think. Instead, they follow the momentum and have been very successful at it. People who ignored valuation metrics and invested in Nvidia are making a killing now.”

Further, the number of retail vigilantes in the market has grown. These are retail traders who are not focused on companies valuations and other fundamentals.

However, some analysts believe that fundamentals and valuations still matter. They point to a company like Tesla that has plunged recently as the EV industry fades. Other companies in the sector like Nio, Xpeng, and Rivian have also slipped.

As such, these analysts caution that these high-flying companies will face their moment of reckoning if their growth trends slow.

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