The industry’s stock sales signal that investors are finally realizing that future growth cannot justify ludicrous valuations.
Who could have foreseen the sale of stocks of big tech companies? Anyone who bothers to do some math.
Technology stocks take a historic blow. The average tech stock in the Russell 3000 Index fell 44% from its 52-week high, and many fell much more. About a quarter of the roughly 400 stocks in the industry fell more than 60%, mostly smaller companies. Yet the big tech didn’t hold up any better. Amazon.com Inc. is down 43% from its 52-week high. Netflix Inc. fell 73%.
The collapse of overhyped tech startups might not be surprising, but investors certainly couldn’t have predicted tech powerhouses would receive similar treatment.
Or can they? When Amazon’s shares began to bend last July, they were trading at more than 40 times Amazon’s expected earnings for the current fiscal year. That’s high even for a growth stock. The futures price-to-earnings ratio for the Russell 1000 Growth Index has averaged around 20 since 1995, the longest period for which numbers are available. (The Russell 3000 Growth Index average is roughly the same, but the dataset is shorter, going back to 2006.)
Either Amazon investors paid more than twice the historical average for a growth stock, or more likely, they expected future growth to justify the company’s overvaluation. One way to measure these expectations is to calculate the implied gains of the stock price at 20 times the long-term average for growth stocks. By that measure, investors’ expectations were ludicrous. To justify its 52-week high last July with 20x forward earnings, Amazon will have to post a profit of $187 per share. That’s a far cry from the $17 that stock analysts expect Amazon to achieve this year.
How much? Analysts also expect Amazon’s revenue to grow 12% this year, more than double the historical average revenue growth for the Russell 3000 Growth Index. Even at this high pace, and based on Amazon’s historical average margin of around 3%, it would take more than two decades for the company to generate earnings per share of $187. And that might be optimistic because it’s not easy for a company as big as Amazon to sustain this level of revenue growth.
For perspective, consider that since 1995, it has taken an average of four years, and often less, for earnings to meet expectations baked in the Russell 3000 Growth Index. Investors don’t get hung up on too much and can quickly change their minds in extreme cases. At the height of the dot-com craze in 1999, 20 times the growth index meant earnings of $33 per share, almost three times the index’s earnings in the previous fiscal year. To meet expectations in four years or less, profits needed to grow at least 27% per year, almost four times the index’s historical average earnings growth of 7% per year.
Investors rushed to the exit when they realized that their growth prospects were unattainable. The Russell 3000 Growth Index fell more than 60% over the next two years, lowering valuation and earnings expectations. Those who bought the growth index after selling it in 2002 waited two years, while those who bought it in 1999 waited 16 years.
Amazon investors have been more patient, waiting an average of seven years for their earnings expectations to materialize, but they also have their limits. Those who paid a fortune in Amazon stock in 1998 had to wait 20 years for their earnings to catch up, but probably not much, as the stock lost 98% of its value from 1999 to 2001. As with the broader growth index, investors who bought the stock at a more reasonable value in 2002 waited only two years for earnings expectations to materialize.
Amazon investors still expect a lot, even after the stock’s sharp decline. Amazon shares are now trading at 54 times this year’s earnings. As analysts expected, even if profits return next year, the stock could trade close to 30x, which is non-negotiable.
The same analysis goes for Netflix, except that Netflix is trading at 17x this year’s earnings, up from more than 50 a few months ago. Netflix should have little trouble delivering the growth that investors expect from its current valuation. The same goes for Google parent company Alphabet Inc., which has traded at 18 and 14 times its earnings this year. and Facebook parent company Meta Platforms Inc. can also be said for Apple Inc. 22 times is not far.
But Amazon isn’t the only mainstay. Among the giants Tesla Inc. It’s trading at 55x this year’s earnings, and Salesforce Inc. It trades 34 times. Don’t be surprised when investors decide that the remaining high flyers won’t live up to high expectations too soon.
Nir Kaissar is a Bloomberg Opinion columnist covering the markets. He is the founder of Unison Advisors, an asset management firm.