- Nvidia’s PEG ratio is below the S&P 500 average
- Meanwhile, Apple’s is way above
When the S&P 500’s valuation reached 23 times its forward earnings estimates in August 2020, the story was that ultra-low interest rates meant there was nowhere else for investors to put their money. That suggested that when rates increased, the market would crash. Well, rates did increase, the market didn’t crash and, on some metrics, the S&P's valuation has hardly diminished at all.
True, on a forward price/earnings (PE) basis there has been a devaluation. In October last year, when inflation appeared to be running out of control, the market valuation bottomed at 15 times forward earnings, according to FactSet. That made sense, given that the previous 10 months had seen 10-year US Treasury yields increase by 2.3 percentage points to over 4 per cent.
However, since then, the S&P's forward earnings multiple has crept back up again to almost 19 times. The inflation story has eased a bit. Both the Bank of England and the Federal Reserve paused rate hikes last week. However, neither has shown any indication of cutting rates.
Given the previous hikes, current valuations could arguably only be justified if we expect companies to significantly increase earnings growth. However, analysts aren’t expecting that, at least not in the coming year, as can be seen in price/earnings growth (PEG) ratios. This metric takes the PE ratio and divides it by the growth rate over a certain period.
Which growth rate you choose is up to you. It could be historical, which might make sense for some sectors or businesses – and certainly has the advantage of a track record – or it could be projected.
FactSet's forward PEG ratio takes the forward PE and divides it by the consensus medium-term annual growth rate. Currently, most analysts are expecting company earnings growth to be slow next year because of worsening economic conditions. For reference, a PEG ratio of 1 is usually considered fair value. Currently, the S&P 500 is trading on 1.34, which is higher than at almost every point in 2021, a time when the global economic outlook was much sunnier.
Apple (US:AAPL) stands out as particularly highly valued on this metric. Analysts are expecting negligible revenue growth in the coming year, meaning the iPhone maker is trading on a forward PEG of around 3, as high as it has been at any time in the past four years. Similarly, Microsoft (US:MSFT) is trading on a forward PEG ratio of 2, higher than at any point since mid-2021.
Microsoft’s share price has been driven up by the hype around artificial intelligence (AI). One of the only companies that has real AI revenue is Nvidia (US:NVDA). The AI chip designer has doubled its revenue in the past year and is expected to keep growing at a healthy rate. Correspondingly, its forward PEG ratio remains a very affordable-looking 0.78.
History tells us the stock market goes up in the long run, but not without momentary losses of faith. If an acceleration in earnings growth (be it AI-generated or otherwise) doesn’t arrive promptly for more than a few choice businesses, expect faith to be tested again.
