Magnificent 7 valuations challenging yet achievable – Old Mutual

The Magnificent Seven set of American tech giants company valuations do not seem to be based on completely unrealistic future earnings growth expectations and while some expectations are demanding, they may not be entirely unattainable.

This is the view of the chief investment officer at Private Clients by Old Mutual Wealth, Andrew Dittberner. 

The Magnificent Seven are the tech giants Microsoft, Apple, Nvidia, Amazon, Alphabet, Meta Platforms, and Tesla.

These stocks’ valuations have generated considerable attention, with the companies’ share prices skyrocketing since the end of 2022. 

Critics argue that these companies’ valuations are unjustified, with some comparing them to the Dotcom bubble of the early 2000s.   

The advent of generative AI language models, like ChatGPT, has provided the catalyst for the surge in the share prices of the M7 companies. 

Over the past 11 years, the collective market capitalisation of the Magnificent Seven companies has grown from just over US$1 trillion to well over $13 trillion. 

This represents a remarkable compounded annual return of 24.3% – doubling the S&P 500’s capital return of 12% over the same period. 

Unsurprisingly, this growth has seen the Magnificent Seven’s contribution to the S&P 500’s market capitalisation soar from 10% to over 30%.

Old Mutual Wealth analysed the fundamentals of these businesses and the market expectations for growth in the years ahead. 

This revealed that this set of companies is not overvalued, and the market is pricing in modest growth for some of the largest members of the elite club, such as Microsoft and Apple. 

The key question is whether the companies’ fundamentals have kept pace. The companies’ earnings have grown from US$9.8 billion in 2012 to $53.1 billion today. 

This earnings growth has notably lagged behind the expansion in market capitalisation, suggesting that they are more expensively valued than in 2012. 

Old Mutual also independently calculated each business’s 10-year earnings per share (EPS) growth, shown in the table below.

Some companies have undergone significant share buyback programmes, which skews these figures. 

The EPS numbers vary widely, with well-established businesses showing more modest growth compared to their younger counterparts, still ascending the J-curve towards higher earnings. 

Are the valuations justified?

Looking at the historic earnings from a valuation perspective has many flaws, particularly for fast-growing businesses. 

Instead, Dittberner said, one must assess what the market is pricing in for the future and then determine whether the companies can meet those expectations. 

For this analysis, we used a 10-year high growth period before reverting to a more stable long-term growth rate. 

To calculate a suitable discount rate for each company, we used current 10-year US treasury yields as a proxy for the risk-free rate. The results are summarised in the table below.

It is clear from the second column that the market is not extrapolating the prior years’ earnings growth into the future, as all the companies would be trading significantly higher if that were the case. 

More importantly, column three shows the market’s expectations for these companies’ earnings growth over the next decade before reverting to a stable growth assumption.

Overall, the results shown in the table below indicate that most companies are not priced for exorbitant future growth.

In fact, the growth assumptions for the two largest companies – Microsoft and Apple ­– are in the high single digits, a seemingly achievable target. 

Thus, Dittberner views comparisons between the Magnificent Seven and the Dotcom era as an exaggeration, given two key differences in the current landscape. 

Firstly, the Magnificent Seven are all highly profitable, unlike many Dotcom-era counterparts.  

Secondly, Magnificent Seven company valuations do not seem to be based on completely unrealistic future earnings growth expectations. 

However, Dittberner urged investors not to consider the Magnificent Seven as a collective but rather as an individual company.