Tech stocks have risen sharply in value in recent years. Jason Bohnet explores whether these high valuations are justified.

What should prudent investors make of a company like Amazon? Logically this should be an easy question, given the firm trades on a price/earnings (p/e) ratio of almost 300.

True, earnings are growing quickly: look out to 2020 and the p/e ratio falls to a slightly less stratospheric 37 times, based on analysts’ consensus forecasts. But that is still three years away and plenty could go wrong in the interim.

Amazon is an extreme example, in part because investors expect it will one day cease sacrificing margins in pursuit of expansion and market share and deliver substantially higher profits. However, other popular tech stocks also trade on punchy valuations. In the US, Alphabet trades on a p/e of 33, Facebook on 37, Microsoft on 33 and Netflix on 219. Chinese peers include Alibaba and Tencent on 56, Baidu on 35 and JD. com on an eyebrow-raising 4,500 (falling to a modest 87 this year, based on consensus forecasts).

It is easy to see why many value-oriented investors view the tech sector as an irrational bubble set to burst dramatically when sentiment turns. Still, there are a couple of compelling arguments why these firms may be able to justify unusually high valuations.

Growth potential

The first is the amount of scope they may still have to grow. Historically, it would be highly implausible that companies already among the largest in the world can reasonably be expected to grow at the kind of pace implied by their current valuations, which are more consistent with valuations that might be applied to a small-cap growth stock. 

However, the trend in recent years has been for a smaller number of very big companies to account for a larger share of the economy. The Fortune 100 list of America’s biggest companies accounted for 46 per cent of GDP in 2013, up from 33 per cent in 1994, according to calculations by The Economist. And not only do larger companies dominate their domestic economy to a greater extent, but their opportunities now encompass the globe – especially for technology firms that have less need to ship physical goods or employ a large workforce on the ground in every potential market. These companies are also benefiting from a secular shift in society, as technology becomes an increasingly important part of everyday life. Hence the limits to their maximum size may be further off.

Take Amazon: under Jeff Bezos’s capable leadership the company is using its growing clout to move into new and potentially more profitable areas. As more customers sign up to its flagship ‘Prime’ platform, Amazon has become more powerful relative to its suppliers, creating a ‘flywheel’ effect that has been levered to lower prices (boosting sales) or move into high-margin businesses like advertising and cloud services. Consequently, Amazon has seen accelerating free cash flow. Assuming this trend continues, it is possible the company’s earnings-per-share will rise from under $5 last year to about $60-70; this would take the p/e ratio from 300 to around 20 within a five-year period. Suddenly the company doesn’t look so expensive.

Similarly, Facebook has been able to rapidly expand its offering – partly by acquiring other companies such as Instagram and WhatsApp – and to monetise mobile in a way that commentators who raised eyebrows at its valuation thought would be impossible. The firm’s vast user base also gives it a durable moat against competition, another factor for investors to consider.

Regulatory risk?

There is, of course, a risk governments and the public become increasingly discomforted by the power of large companies and seek to regulate them more closely. That concern certainly can’t be dismissed – but it is worth remembering aggressive moves to break up or drastically restructure large companies have been unusual.

So while governments may well want large tech firms to regulate online content more carefully or demand they pay more tax, it does not mean they will want to curb their growth. Would breaking Amazon up really be best for its customers or the economy overall? It has lowered prices (on both retail items as well as computing), and introduced new innovations that have raised the bar for its competitors. Free shipping used to be the exception, now it’s the rule. Take down Amazon and these benefits would likely disappear.

You also need to consider that a few large near-monopolies are more easily regulated than lots of smaller firms. In China, for example, a few giant firms dominate the Chinese tech sector despite a high level of regulation for internet businesses.

Lessons from history

Over the long term we expect the large tech firms will merit their valuations.

Looking deeper, reported profits may be an increasingly patchy guide to a firm’s true value, as some intriguing research by Feng Gu and Baruch Lev hints. They point to the fact that tech companies are increasingly prioritising investment in areas such as software development and design – which are expensed when calculating earnings – over investments in physical assets (which are capitalised). The former may pay off handsomely over the longer term.

This is not to say these companies will not encounter challenges along the way. There may be a useful comparison to draw here with the fate of the Nifty 50, the high-priced growth stocks of the late 1960s and early 1970s. Despite high valuations at the time, Nifty 50 firms in healthcare and consumer staples – which spent heavily on R&D and were often light on tangible assets, like today’s big tech firms – tended to outperform the S&P 500 over the next 30 years, although many of them also de-rated viciously during the 1973-1974 bear market.

This episode suggests investors should be wary of tech companies being punished during a major bear market. But over the long term we expect the large tech firms will merit their valuations, at least as far as the well-entrenched, highly cash-generative giants are concerned.

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