No, Tech Companies Are Not To Blame For The Overvaluation Of The Market

Includes: QQQ, SPY
by: Diesel

The market is at lofty valuations based on every metric out there.

Many people blame tech companies for this issue.

In fact, tech might be the only sector that is not grossly overvalued.

By now, everyone knows that the US stock market is vastly overvalued no matter what metric you look at. The average P/E is 21 versus a historical average of 14, the average price to book value is 3.4 versus a historical average of 2.8, the average price to sales ratio is 2.1 versus a historical average of 1.5 and the average dividend yield is 1.9% versus a historical average of 4.3%. Many people blame the tech industry for this overvaluation, arguing that the rest of the market is quite cheap if you exclude tech companies.

In this article, I'll show how this is not the case and how some tech companies might actually be the cheapest companies in the market today. Investors can benefit from moving some of their money to companies that are on the cheaper side with low debt levels and lots of cash, many of which happen to be in the tech industry.

First, let us look at some non-tech consumer companies and their valuations. In the below chart, you can see that P/E ratios for some of the most well-known customer staples range from 24 to 36, anywhere from 14% to 71% above the market's average P/E. These companies are some of the most invested consumer staples, and none of them are considered "tech" companies, yet they all have very lofty valuations.

Chart Data by YCharts

Let's look at this from a different angle and look at how these companies' P/Es performed compared to their historical averages. As you can see below, P/Es of these companies expanded anywhere from 61% to 176% in the last 10 years. Basically, investors are willing to pay more and more for each dollar of profit these companies generate. It is typically not a good sign when most of the capital appreciation in a company is coming from P/E expansion rather than organic growth, especially if we are looking at customer staple companies with single-digit growth rates. Anyone who is buying one of these companies today is basically betting that investors will pay more and more per profit for these companies in the future. In other words, when you bet in one of these companies, you are betting that their P/E will expand even further than these lofty levels.

Chart Data by YCharts

Some say that people buy consumer staples because of dividends rather than capital appreciation as these companies typically have a long history of paying and raising their dividends. Let's check dividend yields next. We can see that with the exception of 2 companies, all of them saw their dividend yield drop in double digits, some as much as 71% in the last 10 years. Not only investors are willing to pay more money per profit a company generates, they are also willing to get less and less in dividends in return. This is the kind of behavior you see in market tops and towards the end of bull cycles and this is definitely not a great sign.

Chart Data by YCharts

Compared to these companies, even the infamously expensive tech industry looks cheap. In order to compare different companies in different industries with different growth rates, one metric I'd like to look at is PEG. This metric takes P/E to the next level and introduces the actual growth rate of a company to tell us how reasonable a company's current P/E is compared to this rate for an apples to apples comparison. The lower a company's PEG is, the cheaper a company's P/E is considered to be compared to its growth rate. A PEG of 1 would indicate fair value, a PEG closer to 0 would indicate cheapness and anything above 1 would indicate a company being too expensive.

As you can see in the below chart, tech companies tend to have some of the lowest PEGs in the market with Oracle (ORCL) having 0.08, Intel having 0.11, Microsoft (MSFT) having 0.20, and Alphabet (GOOG) (NASDAQ:GOOGL) having 0.39 whereas some non-tech companies have much higher values such as P&G's (PG) 2.21, Costco's (COST) 1.61 and McDonald's' (MCD) 1.94. In addition, tech companies tend to have higher margins and much larger cash reserves with much lower debt levels, which makes them more attractive.

Chart Data by YCharts

So I'd stop blaming the tech industry for the lofty valuation of the market, as a lot of non-tech companies are also overvalued, in some cases even more so than the tech giants. I'd even say that some tech giants might be safer bets in the face of a recession than customer staples. For example, people won't stop going on Facebook and Instagram just because we are in a recession. People certainly won't stop using Google or YouTube. Companies won't suddenly stop using Microsoft Office as this is an essential product for many companies. Apple (AAPL) might get affected by recession more than other tech companies because it is basically a consumer electronics company, but Apple's current low valuation (P/E of 15 vs. market average of 21) already prices in much of that risk.

Besides, tech companies are sitting on mountains of cash with relatively low debt levels and high margins so they will be okay even during a recession. Of course, I wouldn't be doing my job if I didn't mention that there are also plenty of tech companies with lofty valuations and not as much margin of safety, such as Netflix (NFLX), Amazon (AMZN), Uber (UBER) and these companies definitely play a role in lofty valuations of the overall market, but I wouldn't put all blame on the tech sector.

Investors can benefit from moving some of their money to companies with high margins, low debt and solid growth rates and it so happens that a lot of these companies are in the tech industry.

Disclosure: I am/we are long SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.