Growth Stocks Less Expensive Than Meets the Eye

Clients and some advisors for that matter are often conditioned to believe that paying up is the logical course of action when it comes to accessing growth stocks. It’s merely the cost of admission or so market participants are led to believe.

Indeed, valuation alone isn’t a reason to buy or sell stocks. It’s also possible for price-to-earnings ratios (P/E ratio) to climb higher in unison with stocks. Currently, the Nasdaq-100 Index (NDX), which typically sports an above-average P/E ratio relative to other broad market gauges, sports a P/E of about 27x. That’s pricey, but not as high as the gauge has been in the past.

On the other, it’s downright expensive relative to the S&P 500, which trades at 18.8x earnings. Regarding that index, that P/E ratio is 8% above the historical median. Translation: As measured by traditional valuation metrics, domestic large-caps are currently expensive.

Compounding that scenario is the fact that over the past several years, particularly among large- and mega-cap growth stocks, share prices rose far more rapidly than did earnings. Still, an important point is getting lost in the shuffle: Traditional valuation metrics, such as P/E and price-to-sales, while useful, can paint pictures of high valuations that really are not.

What’s Missing

Advisors are likely familiar with the concept of Generally Accepted Accounting Principles (GAAP). GAAP earnings are important, but they don’t always offer market participants a full valuation. That’s particularly true when it comes to growth companies.

Many of today’s technology leaders have robust portfolios of intangible assets that are pertinent to investors, but are often overlooked when it comes to valuation.

“Internally generated intangible assets are largely missing on financial statements, causing book equity values (which equals assets less liabilities) to be understated,” according to WisdomTree research. “And because investments related to intangible assets (like research and development) are to be immediately expensed rather than capitalized, companies are building large intangible assets when investing aggressively in R&D and understating true earnings relative to companies who depreciate physical assets over future years.”

In other words, a case can be made that not only are tech companies punished due to the R&D-intensive nature of their industry, that punishment (ignoring intangible assets) stokes the appearance of stocks that richly valued based on traditional valuation metrics.

Why Intangibles Matter

Intangible assets are just that: Assets. That means those assets should be considered by investors looking to build a more accurate valuation representation. Using the S&P 500 Expanded Tech as the measuring stick, when intangible assets are included, the index’s premium to the S&P 500 decreases. Likewise, the S&P 500’s valuations decline.

“Using a revised intangible adjusted P/E, the S&P 500 Tech+ Index valuation is only 25% greater than the S&P 500—down from the nearly 60% premium in traditional P/E ratios,” adds WisdomTree. “The S&P 500 P/E itself also drops 20% from 22.5 times to 18.0 times, showing the market is less expensive than traditional measures imply. The historical median discount looking at the S&P 500 P/E on the intangible adjusted measure versus the regular P/E has been 18%.”

Bottom line: What makes companies, particularly those with the growth label, valuable to investors is evolving. How market participants value stocks should follow suit.

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