A recent client question:

Q: “Have you done any work on the multiple of the S&P 500 and the growth rate and margin/profitability of the S&P 500? Many strategists say margins are peaking for the S&P 500, margins can’t go higher and that the multiple therefore can’t go higher. But one view is that we have never had a period before when the biggest stocks in the S&P 500 have grown at the rates that NVDA, AMZN, GOOG, AAPL, MSFT etc. are growing, i.e., when JPM and XOM etc. were the biggest stocks in the index they would not have grown at the same rate with the same margins. Therefore, you can potentially make the case for higher multiples now. What’s your take?”

 A: Yes, this is part of the market valuation analysis I do, and elements of it are often featured in the Mill Street’s institutional research reports, but I wanted to share my updated response to this topical question here. I last wrote about it here in October.

S&P 500 valuations are higher, but so is profitability

The S&P 500 index P/E (and other valuation metrics) is indeed high relative to history (though nowhere near the 1999 bubble peak). But the average (median) stock in the S&P 500 is not especially expensive, so it is in fact the biggest companies that are pushing the cap-weighted index P/E up.

Source: Mill Street Research, Factset

A key factor is that S&P 500 profit margins are much higher than they have been historically, and the same is true for Return on Equity. These are of course the critical inputs for valuation models, and the moves have been significant: operating margins have risen from 10-11% in the mid-2010s to around 13% now, while ROE has risen from around 16% to just above 20%. Assuming that these readings continue could certainly justify a higher multiple in a traditional valuation model.

Source: Mill Street Research, Factset

Note that this is very much NOT the case for small-caps, as the S&P 600 Small-Cap index has lower-than-usual margins and ROE, so the higher profitability is clearly a mega-cap trend, not a broad-based pattern for all companies. Margins are not as high outside the US, but the MSCI All-Country World Ex-USA index (ACWI Ex-US) aggregate margins have risen significantly as well, indicating mega-caps outside the US are also getting a profitability boost.

Source: Mill Street Research, Factset

Why have US mega-caps become more profitable?

 In recent years, it has been a “the big get bigger” backdrop, and US Technology-related stocks are the dramatic example of that.

Some key reasons:

• Economies of scale: many big industries like Technology (also Pharma, and some Financials) have high operating leverage, i.e., high fixed costs and low variable costs. So rising top-line sales push margins up more quickly (though it can work in reverse if sales fall). They also often have multiple business lines that support each other (e.g. hardware and software/services). This has clearly been the case for many US mega-caps. We can see this in the rising ROE: earnings rising faster than book value over the last decade or more.
• Network effects: companies that can capture network effects (like operating systems or platforms: everyone uses it because . . . everyone else uses it) can have high growth and high moats, and those have been more important in recent years, especially in Technology.
• Regulatory influence: big companies can (and do) lobby government and regulators to their benefit, and have often been allowed to buy smaller rivals who might be a threat, or otherwise get legal/regulatory advantages.
• Corporate tax cuts: the Tax Cut and Jobs Act of 2017 lowered US statutory corporate tax rates significantly, which did help boost after-tax earnings, but was most beneficial for large profitable companies rather than smaller companies (and no help to companies without earnings). And the profit margin expansion has been driven to only a moderate degree by lower tax rates, as EBITDA margins for the S&P 500 (i.e., earnings before interest, taxes, depreciation, and amortization) have risen significantly as well: from 18.5% in 2011 to 21-22% currently.
• Balance sheets/interest rate sensitivity: big profitable companies mostly do not need to borrow and often have lots of cash on the balance sheet, and often have higher credit ratings, so they get a significant relative benefit when rates go up compared to smaller and less profitable companies (who do have to borrow). Relatedly, the rise in ROE has not been driven by higher balance sheet leverage for the S&P 500, as the S&P 500 is less levered now than it has been since the mid-2010s.

S&P 500 and S&P 600 interest coverage and debt/assets ratios are shown below: large-caps have reduced debt/assets ratios and kept interest coverage (operating cash flow relative to debt interest expense) at solid levels despite higher rates, while small-caps have significantly higher leverage and seen interest coverage decline sharply (in addition to more debt, smaller companies tend to pay higher rates on average).

Source: Mill Street Research, Factset

 Are current multiples justified?

From 2011 (first full year after Great Financial Crisis effects wound down) to 2024, S&P 500 nominal earnings rose at a 7.0% annualized rate, as did free cash flow per share. Dividends per share rose at an 8.1% annualized rate. Top-line sales rose at a 4.6% annualized rate, which is right in line with nominal US GDP growth (which of course includes the short but quite sharp decline in 2020 due to COVID).

And it is not just a recent trend: S&P 500 earnings actually have been growing much faster than inflation for most of the last 30 years. This tends to give investors reason to pay higher multiples.

If the US can continue to produce 2-2.5% real GDP growth with around 2-2.5% inflation, then 4-5% nominal growth is a reasonable prospective top-line growth rate. Getting to the historical ~7% earnings growth rate would require either higher nominal growth, or somewhat more margin expansion (or taking more ex-US market share).

How we do equity market valuation

As we have discussed in this space previously, our own valuation framework estimates the long-run growth rate of real (inflation-adjusted) earnings built into stock prices (S&P 500) and compares it to real corporate bond yields, taking into account normalized (i.e., cyclically-adjusted, 10-year average) earnings, and the economic backdrop (risk premium). Right now, that estimate is for about 3.8% average annual real growth in earnings being priced in. One could arguably adjust the assumptions to produce a lower figure (i.e., the inputs are likely conservative), but the clear message is that growth expectations are much higher now than they were since before COVID (readings around 2% were more typical in the 2010-2019 period). This is visible in the green line in the bottom section of the chart below.

Source: Mill Street Research, Factset, Bloomberg

For comparison, the actual historical growth rate of real S&P 500 EPS has been above 4% over the last 20-25 year period (even with 2008 and 2020 in the data), and the rolling 20-year growth rate has not been below 3% since the mid-1990s, so our model’s 3.8% estimate is not extreme relative to the actual growth rate of real earnings in recent decades, though above most estimates of US long-term real GDP growth.

Source: Mill Street Research, Standard & Poor’s

So the question, as always, comes down to whether you think the recent trend of 4%+ real EPS growth can continue, or if it is due to slow down. A key reason the implied growth rate has risen is that real bond yields are higher now, so there is more competition for investor funds (a higher “hurdle rate” to beat, in a backdrop of reasonably good economic growth and tighter monetary policy) than there has been in quite a few years. So if real bond yields fall, relative stock/bond valuations could improve without stock prices declining.

The bottom line is that earnings for the S&P 500 do not have to grow at extraordinary rates for stocks to do fine, but expectations are clearly higher now and thus there is more potential downside if growth does slow down for some reason. The undervaluation of stocks vs bonds we saw for most of the post-COVID period is gone now (mostly because the Fed raised rates a lot and bonds did terribly), but stocks do not seem aggressively overvalued, just more fully valued. We are still far from the relative valuation levels seen in the 1999 bubble period (when our model showed 6-8% long-run real growth expectations).

If you think the mega-cap leaders in the S&P 500 will face some major headwinds (e.g. government breaking them up, failure to innovate and create new high-demand products, overspending on unprofitable ventures, etc.), then you would “take the under” on the market’s current growth expectations and likely favor bonds over stocks. Otherwise, a continuation of the last 10 year trend would suggest that while we may not get 20%+ annual returns in stocks (as in 2023-24), we could still get solid positive returns a while longer (like the last “soft landing” in the mid/late 1990s), especially if rates gradually decline.

Sam Burns, CFA

Chief Strategist