Money Guide | Big-Tech valuation bets
Also: Indicators, World Watch, Quick take, Weekly Agenda, News, Musings, Opportunities
Money Guide is a personal project, supported by paid-subscriptions. I hope that all readers find the news timely and relevant, the musings interesting, the opportunities attractive, and my thoughts enriching and provoking
Take advantage of this limited-time offer:
In this issue: Recession warnings, AI frenzy, Crypto regulation proposals, Mexican rail seizure, Dollar backlash, Liquidity drain, Oil price threat, Copper tumbles, Racehorse equity and a few thoughts on Big-Tech valuation bets
Indicators
The Money Guide Indicators provide you with a macro overview at a glance of financial markets and more detailed information when you zoom-in
Do you want to know more about its components and how are they evaluated?
Part 1: How to read the Indicators from Money Guide
Part 2: Inflation Rates, Central Banks' Rates, Sovereign Bonds, Currency Exchange Rates
Part 3: Commodities, Stocks, Crypto
World Watch
The Money Guide World Watch provides you with a macro overview at a glance of the main situations that can negatively influence economic and financial markets
Do you want to know more?
2023 Threats
2023 Threats’ status updates
My Quick Take
🔒*** ** ********** ******* * **** ******* *********. ******** ******* ******* *********, *** ** ******** **** **** ** **** ***** *** **** **** *** *** ** ********* *** ********. **** **** ***** ********* **** ***** ******, *** *** **** * ******** ****** ** ***** ******.********** *** **** ******* ****. ************ ***** ***** *** ***** ** * **** *****, *** ************** ***** *** ****** ******** ****** ** *** *.**** ************** ** ********* **** ****** **** **** ******* ******.
** *** ********* **** ******** ****** ******** ***** ***** **** ** **** ***** *** **** **** ** **** ********, *** ********* ***** ******* ** ******* ** ****** ************.
******** ********** ***** **** ******* ******** ****** **** ****** ******, ****** * *******, *** *** ** ******* *********** ** ***** **********.****** ******* ******* *** ******* ***** **** **** ** ***** ******** **** ********** ****** ******, ******** ****** **** **** ** ****** ****. *******, ***** ** *** ** *** ****** ****** ***** ***** ***.*** **** **** ** *** **** ** *** *** * *** **** ********* ** ** ***** **** *** **** ********* ****, ******. ** ************** ******* ** *** ****** ***** ***** **** ** *.** ** ****** ****.******* *** ******* *** ******** *** *********** ******** ** ***** *********.************ **** **** ***** **** ** ***** *************** ******, *** ******** ***** ********* **** ****** ** *** ********, ****** ** ******* ******** **** ********* *******.********* * ******* * ************* ********* ** ****** ****** **** ******** ****** ***** **** ***** ** ********* ** *** ** ***** ******* **** ***** ***** ******* ******, **** ******** *** ** ******* ********* ***** ** ******* **** **** ******* ******.*** *** ***** ** * **** ********** *****
**** ******* *****
********* ***** ***** ****
**** * *********
*** *** ****** *** *************
*** *** ******** *** *********
*** *** *** ****** *** ********🔒
Colored circles in Money Guide refer to estimations of possible economic and financial impact:
🟢=positive mid-term forecast
🔴=negative mid-term forecast
⚪=neutral mid-term forecast
Weekly Agenda
All times are US ET (UTC-4)
Monday, June 5
10:00 🔒 US ISM Services Purchasing Managers’ Index (PMI) report
(Previous: ***, Expected: ***)
10:00 🔒 Apple Worldwide Developer Conference (WWDC)
Tuesday, June 6
00:30 🔒 AU RBA Interest Rate decision
(Previous: ***, Expected: ***)
Wednesday, June 7
--
Thursday, June 8
21:30 🔒 CN Inflation Rate report
(Previous: ***, Expected: ***)
Friday, June 9
08:30 🔒 CA Unemployment Rate report
(Previous: ***, Expected: ***)
*🔒 Forecasts, analysis and additional information locked in the previous sections are available only in the premium edition of Money Guide for paid-subscribers
News
📰 🔴 The Fed's favorite inflation gauge just heated up, and that could mean another rate hike | The Personal Consumption Expenditures price index rose 4.4% for the 12 months ended in April, up from a 4.2% increase seen in March. On a monthly basis, the headline and core indexes were both up 0.4%. In March, the headline PCE index showed a 0.1% gain (link)
📰 🟢 Alarm bells were ringing about a potential US recession, but then this week’s Jobs report landed | Recessions often can be brought about when consumers pull back on spending because they’re worried about losing their jobs. But despite some high profile job cut announcements in certain sectors, for the most part, workers right now don’t have to worry about that (link)
📰 🔴 Euro-zone factories flounder with activity shrinking at fastest pace since pandemic | The PMI numbers do still signal overall expansion, though they leave a question mark over its pace, potentially casting doubt on whether the euro zone can achieve the growth of as much as 0.4% per quarter (link)
📰 🟢 Inflation in Europe drops to lowest level since Russia invaded Ukraine | Consumer prices in the 20 countries that use the euro rose 6.1% last month compared with a year ago, easing from 7% in April (link)
📰 🔴 Germany falls into recession as consumers in Europe's biggest economy spend less | Output in Europe’s largest economy dropped 0.3% in the first three months of the year, following a 0.5% contraction at the end of 2022 (link)
📰 🔴 Britain is getting so desperate to tame inflation it's talking about food price caps | The cost of store items, known as shop price inflation, rose 9% through the year to May (link)
📰 🔴 China's economic recovery loses steam as factory production contracts further | The world’s second largest economy is still in the midst of a historic downturn in the property market. The country is also gearing up for a fresh wave of Covid-19 (link)
📰 🔴 The 'magnificent 7' Tech stocks drive markets higher as AI mania grips investors | Broadly speaking, investors have soured on the overall market and are piling money into the much-hyped artificial intelligence trade, which is feeding the concentration of market gains into only a few companies (link)
📰 🔴 Share buybacks continue at torrid pace while investors sit on sidelines | US companies have announced $600 billion of share repurchases so far this year (link)
📰 🟢 WEF publishes Crypto asset regulation recommendations | The World Economic Forum published a white paper on crypto asset regulation that focused on the need for stakeholders to work together through coordination (link)
📰 🟢 EU watchdog calls for curbing leverage in Crypto trading | European Union authorities should curb leveraged bets on crypto assets by introducing limits for investment funds, exchanges and other firms to stop shocks in that industry from jeopardizing financial stability elsewhere (link)
Musings
💭 🔴 Corporate bankruptcies are on the rise, and the pain won't end for a while | From Vice Media to Bed Bath & Beyond, bankruptcies are picking up again. Last week, corporate America had its worst 48-hour stretch of bankruptcies since at least 2008, according to Bloomberg. That’s never a good comparison (link)
💭 🔴 Macy's and Costco have a warning about the economy | Macy’s, Costco and other big chains say shoppers are pulling back at their stores and changing what they buy. That could be a red flag for the US economy (link)
💭 🔴 Here's the real reason Target's stock is dropping | If you follow right-wing media or Twitter, you may have seen a lot of coverage recently about Target’s stock price falling. It’s not because of recent LGBTQ backlash, though (link)
💭 🔴 Resilient US junk bond market baffles investors | Scarce supply pushes down high-yield spreads, despite worries about elevated interest rates and recession (link)
💭 🔴 Friday is now an options feeding frenzy as Big Tech meets Zero-Day Options | Rampant demand for Big Tech exposure is combining with the boom in fast-expiring options to fuel an explosion in bullish bets in the first few minutes of Friday trading. That’s the day that weekly contracts on individual stocks expire, effectively turning them into the zero-day options that have become a trader obsession (link)
💭 🔴 Bill Ackman says Carl Icahn ‘somewhat’ like Archegos as stock plunges anew | Bill Ackman said Hindenburg Research has “outed” the way billionaire Carl Icahn runs his publicly traded company and suggested shares have room to fall after tumbling to the lowest levels since 2009 (link)
💭 🔴 AMLO’s seizure of a billionaire’s rail line is making investors wary of Mexico | For global investors, predicting President Andres Manuel Lopez Obrador’s moves has never been easy. And now as he enters the home stretch of his presidency, it might get even harder (link)
💭 🔴 Backlash Against Weaponized Dollar Is Growing Across the World | US increasingly using currency to fight geopolitical battles. Wary world leaders look to lessen reliance on greenback (link)
Opportunities
💡 Debt deal may provide only short-term market relief | The US Treasury is expected to quickly refill its empty coffers with bond issuance, sucking out hundreds of billions of dollars of cash from the market (link)
💡 Company Earnings Guidance Is Wrong About 70% of the Time | Most were confident earnings would fall within guidance. Covid-19 made managers even more confident in predictions (link)
💡 Copper gripped by China fears as prices plunge below $8,000 | The energy transition remains supportive of the long-term outlook for the bellwether metal. But for now, the absence of any big-ticket infrastructure spending announcements from Beijing means there’s no safety net for investors (link)
💡 Saudi Energy minister tells Oil speculators to ‘watch out’ | The Organization of Petroleum Exporting Countries and its allies, a 23-nation bloc known as OPEC+, will meet on June 3-4 in Vienna to review production policy for the second half of the year (link)
💡 Apple WWDC: everything to know about major live event, as headset and new iPhone features expected | New Macs, new features and entirely ‘new worlds’ are expected during keynote reveal (link)
💡 Cathie Wood calls Nvidia stock 'overpriced' after missing 2023 rally | Wood argues there are going to be other winners in the AI space outside of Nvidia (link)
💡 Wall Street banks seizing AI to rewire world of Finance | The AI revolution is unfolding on Wall Street as wider interest grows in the evolving technology and its likely impact on business (link)
💡 A techy, hip and bold new idea is revolutionizing horse racing | The concept is simple: Buy a share in a racehorse -for as little as $50- and then, if all goes well, earn a cut of its winnings (link)
A few thoughts on…
Big-Tech valuation bets
Valuations depend on who you ask. Most sellers will say it’s cheap, while most buyers will say it’s expensive. Knowing the cost is a straightforward process: the sum of all the expenses necessary for its production. Knowing the price becomes a bit harder: the cost plus an added desired profit or discount by the seller. Knowing the value requires a trade: the agreed upon worth, between buyer and seller.
In finance, it is common to hear that the value of an asset can be determined through the expected return on investment. For example:
A coupon that can be exchanged for $10 at a bank, could be said to have a value of $10. If the bank charges a commission of $0.50 to exchange the coupon, maybe its value should be $9.50 instead of $10. If the coupon has a provision that says it pays $10 at a fixed future date plus or minus the current inflation rate, its value would have to be estimated considering that.
Since shares (stocks) represent a proportional ownership of a company, share prices reflect (ideally) the value of that company: the price of all the shares equals the value of the whole company (its market capitalization), including all of its assets and liabilities.
Companies are in the business of making money. What happens to the company profits? Generally speaking, each share is entitled to a proportional ammount of the company earnings (profits) during each specific period. This is referred to as Earnings-Per-Share (EPS).
Investors in a company expect a return when buying stocks, and use future company Earnings-Per-Share as a way to estimate the correct price to buy and sell them.
In a previous post, I explored valuations using the Price-to-Earnings ratio (P/E ratio) model, and explored some examples. I want to explore some more. To keep it simple, for all the examples we will be assuming 0% interest rates and 0% inflation rates, so we don’t have to calculate discount rates and present values.
Let’s start with an easy one. Company A has a steady $10 Earnings-per-Share (EPS) every year, without any kind of projected growth.
How much should investors be willing to pay for a share of Company A?
A 10-year projection, using a 10x EPS multiple, could look like this:
Initial Share Price: 10x EPS = 10x $2 = $20
EPS: $2 (10%) every year = $20 (+100%) accumulated during 10 years
Share Price after 10 years: 10x EPS = 10x $2 = $20 (+0%)
Since Company A has a steady EPS and doesn’t grow or diminish its earnings, every year Company A is worth the same. After 10 years, Investors can sell the purchased share for the same $20. Their net return would be $2 of EPS every year, that adds up to $20 after 10 years. That is a 12% compounded annual return.
It is not a risk-free investment, and the investment is not guaranteed as it might be if Company A was raising capital through Corporate Bonds (debt).
Is 10-12% an acceptable projected annual return for Equity (ownership shares) in Company A?
Conceptually, earning $2 from Company A could be equal to earning $2 from any other company, so the pricing of shares shouldn’t change if there are no other significant differences between them. But some companies are projected to grow and increase their earnings. Historically, the average growth of S&P 500 companies has been 4.5%-8%. Discounting inflation we could consider 4% annual growth as a good reference value.
A 10-year projection, using a 10x EPS multiple and 4% annual growth, could look like this:
Initial Share Price: 10x EPS = 10x $2 = $20
EPS Total: $25 (+125%) accumulated during 10 years
Share Price after 10 years: 10x EPS = 10x $2.96 = $29.60 (+48%)
The net return after 10 years would be $25 (+125%) of EPS and $9.60 (+48%) from the increase in price of the shares ($29.60 final share price - $20 initial share price). That is a 17% compounded annual return.
Since Company B has 4% annual EPS growth, every year Company B is worth more. By keeping a constant P/E ratio, EPS after 10 years are 48% higher and the stock price is also 48% higher. The value of the company increases in proportion to the increase of its earnings. Over a long-term horizon, this tends to occur in real-life markets with fluctuating EPS and multiples.
The long-term average P/E Ratio for S&P 500 companies is close to 16x.
What kind of return on investment can be expected with 4% annual growth and 16x EPS?
A 10-year projection, using a 16x EPS multiple and 4% annual growth, could look like this:
Initial Stock Price: 16x EPS = 16x $2 = $32
EPS Total: $25 (+78%) accumulated during 10 years
Share Price after 10 years: 16x EPS = 16x $2.96 = $47.37 (+48%)
The net return after 10 years would be $25 (+78%) of EPS and $15.37 (+48%) from the increase in price of the shares ($47.37 final share price - $20 initial share price). That is a 12% compounded annual return.
The returns are smaller than in the Company B example. Why? A higher EPS multiple means a higher price for the same ammount of Earnings-Per-Share. All else being equal, the share price after 10 years will increase in the same proportion, because Company C annual growth is still 4%.
When investors pay higher EPS multiples in exchange for higher growth, their returns are diminished. In simple terms: high EPS multiples mean expensive share prices. A high EPS multiple equals a premium, where the investor is paying in advance for the expected company growth.
This year, we have been constantly reading and hearing about Artificial Intelligence (AI), and how it will decidedly change how we live. Investors are rushing to invest in AI companies that can have exponential growth and returns in the coming years. As the saying goes: “when there’s a gold rush, sell pickaxes and shovels".
NVIDIA is one of the main manufacturers of computer processors, and has labeled itself as the “World Leader in Artificial Intelligence Computing”. NVIDIA (NVDA) share prices are nearing $400, with $1.89 Earnings-Per-Share. At $400 per share, NVIDIA is valued at $1T USD, which is 37 times its current annual income (revenue/sales). Those are extreme numbers. And even more important is the fact that NVDIA shares are trading at close to 200x EPS! We said the long-term average EPS for S&P500 companies is 16x EPS. The current average annual growth of NVIDIA is close to 15%, much higher than the average S&P500 company, although it is an average including years of tremendous growth and years of more moderate gains.
Let’s apply those EPS and growth numbers to another example.
A 10-year projection, using a 20x EPS multiple and 15% growth, could look like this:
Initial Stock Price: 200x EPS = 200x $2 = $400
EPS Total: $46.70 (+12%) accumulated during 10 years
Share Price after 10 years: 200x EPS = 200x $8.09 = $1618 (+304%)
The net return after 10 years would be $46.70 (+12%) of EPS and $1218 (+304%) from the increase in price of the shares ($1618 final share price - $400 initial share price). That is a 17.5% compounded annual return.
The compounded annual return is almost the same as in the Company B example, that had a 10x EPS multiple and an average 4% annual growth.
At first glance, one might think that high continuous growth will always result in much higher returns on investments. However, that logic also increases demand for shares of those growing companies, and demand pushes up the current share prices relative to current earnings (a larger Price-to-Earnings Ratio), thus reducing the future return on investment relative to that initial share price. In the case of NVIDIA, those long-term overall returns might be closer to those of other not-so-fancy companies.
NVIDIA investors paying $400 per share today would receive $400 in Earnings-Per-Share during the next 10 years only if NVIDIA grows more than 50% annually! If shares were still trading at 200x EPS after that time, reaching a share price of $28,000 (70 times the initial $400), the compounded annual return would be 61%.
What happens if the current trends can’t be sustained for more than a few years?
If NVIDIA only grows at a 10% annual rate and keeps the 200x EPS multiple, the compounded return would be 12%, which is the average return for S&P companies, as seen on our Company C example. There is a huge difference between a 12% return and a 61% return.
Another possibility is that the EPS multiple and growth rate could gradually get in line with the historic S&P500 company averages.
A 10-year projection, using a starting 200x EPS multiple and 6.5% growth, that gradually descends to a 16x EPS multiple and 4.0% growth could look like this:
Initial Stock Price: 200x EPS = 200x $2 = $400
EPS Total: $34.85 (+8%) accumulated during 10 years
Share Price after 10 years: 16x EPS = 16x $4.47 = $72 (-82%)
The net return after 10 years would be $34.85 (+8%) of EPS and -$328 (-82%) from the decrease in price of the shares ($72 final share price - $400 initial share price)
If NVIDIA gradually returns to the average S&P500 growth of 4% annual rate and 16x EPS, after 10 years the total return on investment could be a 73% loss. And that is even considering that the average growth for that entire period would be 8.5% which is still a very high rate.
Any scenario that considers an investment with a starting EPS multiple of 200x that gradually goes back to 16x EPS, would need at least an average 26.5% annual growth rate to break even after 10 years.
And remember that, to keep all this scenarios simple, we assumed inflation and interest rates at 0%. Discounting to determine present value using rates higher than 0% would considerably diminish those profits and increase those losses.
Which scenario seems more likely? Do you want to place your bets? Would you be willing to pay such a big premium upfront for NVIDIA shares? Just don’t try to short it, you would probably get liquidated. For that you could wait for other wannabe AI revolutionary that are jumping on the bandwagon.
take care, have fun, be chill
-SM
There is more to life than money. Be in the know…
Enjoyed the content?
Subscribe to Money Guide to receive every new edition of The Chosen Many newsletters directly in your inbox, get instant access to all the archives and resources at our website, and join our private channel for additional up-to-date content.
Never miss an update and be a part of the conversation…
Spread the word