Do Valuations Matter Anymore? | Erik Averill, Brandon Averill | AWM Insights #25
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Episode Notes
Last Tuesday, the S&P 500 hit a record high after a sudden and unprecedented decline in the earlier months of the year. Much of the growth has been attributed to 5 big tech stocks, which we covered on a recent episode. As we’ve seen these 5 big tech stocks diverge, it’s made many investors ask if valuations even matter anymore?
While these companies are enjoying their highest valuations ever, we see examples like Apple where their stock price has roughly tripled since early 2019, but so too has its Price to Earnings (PE) ratio. In this week’s episode, Erik and Brandon discuss this recent rise and more, including:
What’s behind the recent all-time high of the S&P 500
What is a Price to Earnings (PE) ratio and why does it matter?
What are the implications of Apple’s stock price and PE ratio rise?
Do valuations even matter anymore?
Can valuations be used as a tool for market timing?
What is recency bias?
The importance of understanding what kind of investor you are and your goals for wealth creation
Resources
For more information on this topic, here’s a great podcast episode that Brandon referenced from The Prof G Show with Scott Galloway.
+ Read the Transcript
Erik Averill (00:00):
Hey everyone. Welcome back to another episode of AWM Insights, where we talk about all things investing. As usual during COVID things continue to be stranger and stranger. And what I mean by that is last Tuesday a week from today, the S&P 500 hit an all time record high. So, I think if we all were trying to project into the future in late February, early March, there was no way anybody would have predicted this, but here we are. And Brandon, the question that I really want to talk about today is as we've really seen these five big tech stocks diverge and continue to just have monumental returns, do valuations even matter anymore?
Brandon Averill (00:44):
Yeah, Eric, I mean, it's a great question. It's a hotly debated topic right now. And I think it is anytime we see margin or a valuation expansion. And I think, where we go back to is if you believe in data, if you believe in going back and looking at the historical results, I think the answer is clearly yes, valuations definitely matter. I think where people get tripped up oftentimes are, they think that if valuations matter that then they should be able to use that as some sort of timing tool to get in and out of different investments. And I think that's what we can hit on a little bit here is, valuations matter over the longterm.
Brandon Averill (01:23):
We know that data shows that valued companies outperform growth companies over long periods of time. However, what we also know is that the valuation metrics are not great timing tools. So, I think the ultimate question maybe you're going to pose is, also defining, who are we? Are we an investor that's trying to make investments to accomplish our goals over long periods of time? Or are we one of these Robinhood traders that really don't probably have a clue, but yet they're going to flip stock to stock and try to make a quick buck? We certainly fall on the investment side of the spectrum.
Erik Averill (01:59):
Yeah. You bring a good point there. And it's interesting. You said, "If you believe in data," I think this is one of the things that we rely so much on here as we always talk about is, what's the evidence to help you capture the highest expected returns in whatever asset class that you are investing in? If you can take us inside an investment classroom real quick, is when you're talking about valuations, people throw out this term P/E ratio all the time, what exactly is a P/E ratio and why does it matter?
Brandon Averill (02:30):
Yeah, I mean, P/E just stands for price to earnings ratio. So basically, what are we willing to pay for the future earnings of a company? And that's essentially one of the most basic valuation metrics that people look at. And we could turn to one of the big tech stocks, let's use Apple as an example. Something really curious has happened with Apple, where we've seen the stock price actually triple since early 2019. But interestingly, we've also seen that ratio essentially triple. So basically, what that's saying is that people are willing to pay three times more for the future earnings of Apple today than they did in early 2019. And fundamentally that's what ultimately probably leads to the realization that value does outperform growth over time. As you bid up prices and you're willing to pay more and more for the earnings of Apple, there's less room for you to benefit from that. So, now Apple has to grow even more exponentially to reward you for the investment that you're making.
Erik Averill (03:34):
So, just to make sure I understand that correctly, people are willing to pay three times more, so a higher price for actually the same amount of earnings that Apple has produced. So, really what they're betting on is saying, they're not producing any more earnings than they were, whatever a year ago, it's more of, they have this huge belief that somehow Apple is going to grow exponentially to be able to provide that return. Am I understanding that properly?
Brandon Averill (04:05):
Yeah. That's exactly right, Eric. And I think we're in a super interesting time, right? We went through a period. I heard professor Scott Galloway has a podcast this past week that hits on this point. I thought fantastically, it just talks about, let's look at the environment right now and who maybe is driving these prices up. We've had Fed stimulus that has fortunately gone to a lot of people. Unfortunately it's gotten to some segments that probably didn't need it. And now we're turning around and we're seeing the growth of companies like Robinhood and these traders that are taking some of those disposable income, sitting at home, there wasn't sports for a while, couldn't gamble, et cetera. Now, so people are turning to the stock market to gamble. That's one explanation that it maybe people are bidding up the price of Apple. But yeah, you're exactly right. I mean, if simplistically early 2019, if Apple was going to pay you a dollar you were willing to pay a certain amount, let's say $5 for that dollar. Now, you're going to pay $15 for that dollar. So, it's a big difference.
Erik Averill (05:11):
Yeah. It makes me think why it's so difficult to detach our emotion from investing, because nowhere else would we be in a situation where it's like, "Hey, we know those pair of Jordan's should trade at 150 bucks and I'm going to sprint out and pay a thousand dollars for them." And vice versa. If all of a sudden we knew something was actually worth $150 and it was on discount for a hundred bucks, we'd buy that all day. But when it comes to investing it's the complete opposite, because emotionally I think we really like owning popular investments. We find reassurance knowing that other people are buying them, right? We are also what's called, recency bias. Like I love to actually look at something that's had success and say, "You know what? They're going to have that success in the future. So, I'm going to dive in and I'm going to buy Apple. I'm going to buy Microsoft. I'm going to buy XYZ, without maybe even doing the real work to make sure that I'm going to capture the return for the amount of risk that I'm taking."
Erik Averill (06:14):
And so, I think returning to your earlier point, Brandon is, this is really for everybody listening to this podcast, is we have to define who we are and why we are participating in the markets. And this isn't a critique against a trader if this is what they're willingly doing is saying, "You know what? I'm actually playing a game. I'm trying to trade in and out of the markets. I'm trying to be ahead of the game. Willingly taking that amount of risk, understanding what they're doing, or am I really a longterm investor? Am I someone who is trying to grow my money so that I can do something with it? What I mean by that is, are you trying to achieve goals? Are you trying to pay for your kid's college? Are you trying to set yourself up for retirement?
Erik Averill (06:57):
Because if that's you, which I believe is most people, every time that you go to try and make a onetime big investment, you're putting all of that at risk. And so, we really believe that there is an evidence-based way to make really smart decisions, and that's what we try to cover every week. So, we hope that you've enjoyed this podcast. As always, you can go over to awminsights.com to access the show notes, the podcast at Brandon reference, we'll make sure to put the link in there so that you guys can check that out. And then, I encourage all of you guys to sign up for the newsletter that's on that website as well. We released some additional articles and tools and tips that you guys can benefit from. So, until then, stay humble, stay hungry and always be a pro.