Recently, the NASDAQ's (NASDAQ:QQQ) strong performance relative to the S&P 500 (NYSEARCA:SPY) has elicited claims that the NASDAQ is overvalued and is destined for a crash in the vein of the dotcom crash of 2000.
We believe that this claim is generally unwarranted, although not without exception.
We believe that absolute index levels are a relatively arbitrary indicator, and that only by comparing the aggregate earnings fundamentals of the underlying constituents can we determine if the index is overvalued.
Based on our examination of aggregate data, we believe that:
(1) Certain cohorts within the NASDAQ in fact trade at lower multiples than the S&P, despite exhibiting:
- Higher growth, and
- Higher profitability
(2) Part of the NASDAQ's outperformance is because the NASDAQ is 'leveraged to the cycle':
- The faster growth of the NASDAQ companies relative to the S&P affords it a higher beta than the S&P in an economic recovery.
- The higher gross margin of NASDAQ companies implies greater earnings scalability
(3) However, we believe that there are pockets of asset bubbles residing with the NASDAQ, and that caution is warranted
- The more expensive cohorts within the NASDAQ do provide cause for concern
- While premium valuations are justified, certain valuations seem far removed from reality
- As we will demonstrate, these concerning valuations are concentrated primarily in internet and biotech companies
A note on methodology:
Index data is not as easy to acquire as those of a particular company. Every online finance website has a slightly different methodology for calculating it.
The NASDAQ is a cap-weighted index, so merely taking a simple average of the share prices and EPS numbers can distort the index PE ratios.
- As such, we are looking at the aggregate market cap of all constituents
- We sum up the total market cap of almost 3,000 NASDAQ companies
- We then look at aggregate revenue, earnings, etc.
Although differing share counts over the course of the year (due to buybacks or issuances) results in P/EPS which may differ slightly from the aggregate data (i.e. cumulative market cap to cumulative earnings), we feel the aggregate data is far superior, as it provides weighted-average data and does not afford the same weighting to 1-800-Flowers.com as it does to Google. (Note: We say this with only the greatest of respect for 1-800-Flowers.com.)
We use the historical FX rate where applicable (as some NASDAQ constituents are non US and report in other currencies).
How Do We Assess Valuation?
We will first examine the NASDAQ as a whole versus the S&P 500.
NASDAQ Versus the S&P
Here we show the NASDAQ in its most broad form. Looking at almost 3,000 companies, we can see that it trades at a significant premium to the S&P on the basis of the important earnings metrics.
- The S&P trades at about 10.2x EBITDA, but the NASDAQ trades at almost 13.0x
- The NASDAQ trades at over 25x LTM earnings, versus under 18x for the S&P
- The NASDAQ trades at 2.4x revenue, versus 1.8x for the S&P
- Importantly, the NASDAQ has gross profit margin 4% higher than the S&P
We believe that higher gross margins are suggestive of greater scalability of NASDAQ companies. In the case of growing companies that have high gross margins, there is the better prospect that the excess margin is capable of flowing through to the bottom line and translating into earnings once these companies reach maturity. 'Cost of Sales' tends to increase in tandem with revenues, but SG&A infrastructure is an investment which tends to increase more slowly.
This suggests a higher potential net income margin once some of the growing NASDAQ companies reach maturity.
In the very long-term, additional competition may drive down net income margins of NASDAQ companies, but there remains the opportunity for greater scalability of NASDAQ companies than in the older, more mature S&P companies.
Next we will segment the NASDAQ into several buckets. We have examined the NASDAQ as a whole relative to the S&P, but we now seek to segment the NASDAQ into the mature companies the pricey companies. We also look at the NASDAQ with each the expensive and cheap cohorts removed. We then compare these to the S&P.
NASDAQ - Excluding the Mature Companies
Here we see that when we exclude the profitable NASDAQ heavyweights such as Apple, Intel, and the like, the index becomes more expensive, with the remainder of the NASDAQ (the NASDAQ Ex-Mature) trading at 31.3x earnings and almost 15x EBITDA. This may be cause for concern, but it not indicative of a bubble in this remaining cohort itself, as the growth may justify these valuations.
The Mature NASDAQ Companies are Actually Cheap
Note the mature company cohort above, highlighted in yellow. The cheaper, 'Mature' cohort of the NASDAQ, with profitable companies such trades at a level that is relatively on par with the S&P 500. We include in this category Apple (OTC:APPL), Intel (NASDAQ:INTC), Cisco (NASDAQ:CSCO), Costco (NASDAQ:COST), Microsoft (NASDAQ:MSFT), Comcast (NASDAQ:CMCSA), 21st Century Fox (NASDAQ:FOXA), Kraft (NASDAQ:KRFT), and Mondelez (NASDAQ:MDLZ).
- EV/Revenue is about 2.2x for the mature NASDAQ stocks versus 1.8x for the S&P; this is because the NASDAQ stocks are far more profitable
- In fact, the mature NASDAQ stocks cohort trade at a lower EV/EBITDA than the S&P: 8.2x vs 10.2x for the S&P
- This means that by this metric, the "mature" NASDAQ stocks are actually cheaper than the S&P
- The Mature NASDAQ stocks also trader at a lower P/E ratio than the S&P, with a weighted average of 14.0x LTM earnings vs 17.7x for the S&P 500. Again, despite faster average revenue growth rates than the S&P, these mature NASDAQ stocks are actually less expensive
- P/Book of 3.0x for the mature NASDAQ stocks is only slightly above the 2.5x for the S&P 500.
NASDAQ - Excluding the Expensive Companies
Cause for Concern: The 'expensive' NASDAQ companies appear very expensive
Removing the expensive companies barely makes a dent In the NASDAQ as a whole; The NASDAQ 'ex-expensive' companies trades at a slightly lower P/E of 23.4x versus the index as a whole at 25.3x. However, this is not hugely significant, as the effect of removing these is too small in quantum to radically affect the index multiples.
However, more distressing is looking at the multiples which the expensive cohort itself trades at:
The "Expensive company total" cohort contains Alexion Pharmaceuticals (NASDAQ:ALXN), Gilead (NASDAQ:GILD), Biogen Idec (NASDAQ:BIIB), Regeneron (NASDAQ:REGN), Tesla (NASDAQ:TSLA), Facebook (NASDAQ:FB), Amazon (NASDAQ:AMZN), Adobe (NASDAQ:ADBE), and Netflix (NASDAQ:NFLX) trade at (see highlighted in yellow below).
This expensive cohort trades at an astounding enterprise value of 6.0x revenue. This cohort also trades at 38.7x TEV/EBITDA. Despite strong growth pipelines from some of the pharmaceutical companies, it is very challenging to see how these companies will grow their profitability in enough to justify these multiples.
Looking at the P/E ratio of 91.7x for this cohort, it is clear that there is indeed potential cause for concern.
To put it into perspective, the 9 expensive companies combined (Alexion Pharmaceuticals, Gilead, Biogen Idec, Regeneron, Tesla, Facebook, Amazon, Adobe, and Netflix) jointly produce less profit in an entire year than Apple produces in a one quarter.
The NASDAQ does not appear to be in bubble territory. In fact, bargains exist within the index, which contains a number of quality companies that are cheaper than the average S&P 500 valuation despite these NASDAQ companies exhibiting durable earnings and robust growth prospects (in many cases).
However, there are decided pockets of concern within the NASDAQ. We appear to be witnessing a bifurcation of the index, where stable companies are afforded less shareholder attention than those with grandiose ambitions and very little profit. Certain internet and pharmaceutical stocks appear quite expensive even giving ample credit to their strong growth prospects. Note only could a turn in sentiment potentially send these companies down to a fraction of their current valuation, but it could create contagion and depress the index valuations more broadly.
A final note is that although the NASDAQ doesn't appear to be in bubble territory when compared to the S&P 500, we note that the multiples of the S&P 500 index itself have also expanded. As such, there remains the chance that equity valuations will decline more broadly. A high beta cuts both ways, and if equity valuations decline more generally, the greater beta of the NASDAQ will likely see its constituents experiencing a steeper ride down.