As the bull market rolls on, one group of stocks is leading the charge…
By now, you’ve probably heard the mainstream media’s flashy nickname for this group. These seven stocks are collectively known as the “Magnificent Seven.”
They are Apple (AAPL), Microsoft (MSFT), Alphabet (GOOGL), Amazon (AMZN), Nvidia (NVDA), Tesla (TSLA), and Meta Platforms (META).
Sure, we all know that the major indexes are soaring so far this year. But the overall market picture dramatically changes if we only look at these seven companies…
The Magnificent Seven’s median gain was 24% over the past three months. Meanwhile, in the same period, the median gain for the 493 outcasts in the S&P 500 Index was only 5%.
That type of outperformance might lead you to believe that the Magnificent Seven are now too expensive. You might even think we should avoid them and buy the 493 outcasts.
Not so fast!
As I’ll show you today, the Magnificent Seven are more attractive than many folks realize…
A price-to-earnings (P/E) ratio alone doesn’t tell you everything you need to know about valuation. In reality, it’s all relative. It depends on the specific company you’re looking at.
In everyday life, that concept is easy to understand. You need to pay more money if you want to live in a better house, drive a better car, take fancier vacations, and more.
It’s the same thing in the markets…
I’d love to buy into chipmaker Nvidia (NVDA) and its artificial-intelligence prospects for 20 times next year’s earnings. But that’s not happening…
I either need to pay up and buy shares at 49 times the company’s projected one-year earnings per share (“EPS”) or take a hike.
Now, I could “geek out” and use math to explain how to evaluate P/E ratios. But I’ll spare you that headache. Instead, a practical approach to a P/E ratio depends on three things…
One is interest rates (meaning “discount rates”). We’ll skip that part of the discussion today because interest rates play a role in stocks across the board – not just expensive ones.
Next is expected future earnings growth. The greater the expectation, the higher the proper P/E ratio. For example, Nvidia will likely generate far too much growth to justify a P/E ratio of 20.
Finally, this approach depends on company quality. Higher-quality companies come with less business risk. So in turn, they can command a higher proper P/E ratio.
With that in mind, let’s compare the Magnificent Seven to the 493 outcasts. We’ll start with the median P/E ratios and expected long-term EPS growth rates…
As you can see, the Magnificent Seven win hands down.
Next, let’s look at company quality…
In the table below, I’m comparing the Magnificent Seven and the 493 outcasts using metrics like the ratio of their long-term debt to equity, interest coverage, and more. Take a look…
In other words, the Magnificent Seven also win big in terms of company quality. Overall, they’re less burdened by debt. And they enjoy higher margins and higher returns on assets.
The bottom line is simple…
Even after this year’s big run, the Magnificent Seven could live with even higher P/E ratios.
With these stocks, the biggest thing to keep in mind before putting money to work is risk. The Magnificent Seven better deliver on their growth expectations – or else.
But the thing is, they didn’t become the Magnificent Seven for nothing. They have a history of meeting – and exceeding – growth expectations.
So as long as the companies come through again, their stocks might even be cheap today.
Good investing,
Marc Gerstein
