The Value Rotation Illusion

Valuation Heatmaps

The FinViz website offers a great perspective on valuations across the S&P 500. Its heatmap (below) shows the P/E ratio for every S&P 500 stock. The “E” is based on the trailing 12 months of earnings. The box sizes are commensurate with each market cap. This layout provides a unique way to view and compare valuations by stock, sector, and market cap.

As the map shows, many companies — large and small, and across most sectors — have expensive P/E ratios of 30 or higher. Conversely, there are very few green boxes with more reasonable P/E ratios.

The P/E ratios shown are a good indicator of a stock's current price relative to its earnings over the last 12 months. There is a benefit to tracking trailing earnings-based valuations; however, we must keep in mind that investors are buying tomorrow’s earnings, not yesterday's. Thus, the forward P/E ratio should be considered alongside the more traditional trailing P/E.

The heatmap below shows forward P/Es. The “E” in these calculations is based on forward one-year earnings estimates. The graphic still shows many red boxes, but fewer are bright red, and more are neutral or green. Forward P/E ratios are not as stretched as trailing P/E ratios.

Sage Advice

Before moving on to a third type of P/E analysis, it's worth recalling Benjamin Graham's logic. Graham was an economist and professional investor, best known for his books Security Analysis and The Intelligent Investor. He is commonly referred to as the father of value investing. His conservative, fundamentals-based approach has guided many successful investors, including Warren Buffett.

In fact, Buffett once said: “Ben Graham was the second most influential person in my life, after my father.”

Given the importance of valuations, let’s consider a few quotes from Graham to help us think about quantifying value stocks.

“The investor should not base his decisions on anticipated changes in the future, but on what is demonstrably true now.”

This quote argues that valuation analysis should be based on prior earnings or forward earnings that are very predictable. Such analysis is fit for well-established, mature companies with steady growth rates. But it doesn’t offer actionable advice for companies that haven't reached maturity, lack earnings, or are experiencing rapid growth.

To this, he said: “Analysis of the future should be limited to what can be reasonably foreseen.”

This quote argues that it's ok to look into the future, but to do so conservatively.

The risk in overestimating future earnings, in his words, is “[t]o pay a substantial premium for growth that has not yet been realized [. . .] to pay twice for the same thing.”

With Graham's sage advice and caution, we look deeper into the future with the PEG ratio.

PEG Ratios

The prior sectionnoted that “investors are buying tomorrow’s earnings, not yesterday's,” and presented valuations based on one-year forward earnings estimates. Compared to trailing P/E ratios, forward ratios better reflect the future earnings investors are paying for. However, one year is far too short a projection for many growth companies.

To project P/E valuation analysis further into the future, investors use the PEG ratio, which divides the forward P/E ratio by the expected growth rate. Generally, a stock with a PEG ratio of 1.0 or lower is considered cheap or a value stock.

Most often, three- to five-year expected annualized growth rates are used for the “G” in the PEG ratio. However, investors can reformulate forward-looking valuations using growth estimates over any number of years.

The graphic below shows that the heatmap using PEG ratios tells a very different story than the two heatmaps shown earlier. Some traditional value stocks and sectors, like consumer defensive (staples) and utility stocks, are predominantly bright red or greater than 1.0. At the same time, some of the fastest-growing companies that were deemed expensive in the first two maps are near or below 1.0.

To better appreciate the PEG ratio, let’s analyze Nvidia and compare it with Walmart.

Nvidia vs. Walmart

Nvidia is considered a growth stock, while Walmart is generally thought of as a value stock. Currently, they both have similar trailing P/E ratios in the low 40s. Using this metric, both are deemed very expensive, as they are nearly double the market P/E. Let's review Nvidia’s growth potential and its three P/E valuations to better appreciate its true valuation.

Nvidia has the following three P/E ratios:

• Trailing P/E: 41.07
• One Year Forward P/E: 25.03
• PEG ratio: 0.54

Nvidia’s trailing P/E indicates the stock is very expensive, but once future growth is incorporated into the analysis, the valuation perception changes. At 25.03, its forward P/E is in line with the broader market. Furthermore, using three-to-five-year forward earnings forecasts, its PEG ratio indicates the stock is very cheap. Currently, the “G” in the PEG ratio assumes a forward annualized growth rate of 46.29%.

If we take a more conservative stance on Nvidia’s potential earnings growth and assume a 25% annualized rate, the PEG ratio is 1.0, which is still considered cheap. At a 20% growth rate, its PEG ratio is in line with the S&P 500 (1.25). Lastly, if Nvidia's earnings grow by 10% annually — the rate of earnings growth expected for Walmart — its PEG ratio would be 4.35.

Forecasting future earnings is a tough task, but as a worst-case scenario, it's fair to assume Nvidia’s growth will average above 20% or more over the next few years. Thus, its PEG ratio is cheap at the current forecast and reasonable in our worst-case scenario. Walmart, on the other hand, could double its forecasted 10% earnings growth and still have a moderately expensive PEG ratio of slightly over 2.0.

The point is that the trailing P/Es for Walmart and Nvidia are similar. But once one-year or three-to-five-year earnings growth forecasts are incorporated into the analysis, Nvidia becomes a value stock while Walmart remains very expensive. More simply, what investors deem to be value (Walmart) is far from value, while the largest growth stock (Nvidia) is truly a value stock.

Summary

Correctly forecasting earnings is impossible. There are many unknown factors, directly related to the company's management and beyond its control, that make any forecast prone to error. In the case of Nvidia, its earnings are dependent on the economy, like most stocks, but closely tied to AI development and data center build-outs, which could turn out to be highly variable. Further, while it has a strong economic moat today, that could erode quickly, resulting in slower earnings growth. However, as shown above, even after substantially discounting earnings forecasts, Nvidia is a value stock.

Walmart’s earnings are less variable and generally correlated with economic activity. Thus, while we can be more comfortable with its forecasts, the odds of its earnings growing at a rate to justify its PEG ratio are extremely unlikely. Although investors assume Walmart is in the value camp, it is anything but a value stock at current price and valuation metrics.

The funny thing is that in this value rotation, many investors are unknowingly shifting from value stocks to expensive ones.

Michael Lebowitz is a portfolio manager with RIA Advisors and author for Real Investment Advice. For more information, contact him at [email protected] or 301.466.1204.

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