Gavekal Capital: Decomposing the S&P 500 PE Ratio by Market Cap: Most Stocks Look Expensive

Thursday, July 17, 2014

Decomposing the S&P 500 PE Ratio by Market Cap: Most Stocks Look Expensive

Back in December we wrote a piece entitled, "Decomposing the S&P 500 PE Ratio: How Can the Market PE be "Low" and Stocks be Expensive at the Same Time?" in which we showed how the market capitalization of the S&P 500, and many other indexes for that matter, is dominated by a few mega-cap companies which distorts index level valuation statistics. It's been a few months so we thought we'd provide an update on that analysis.

In the first below table we breakdown the S&P 500 into three market capitalization categories: top 10, top 50 and bottom 450. From there we show various statistics describing each category including each category's market cap as a percent of the total and each category's forward P/E ratio. What we find is that the top 10 companies by market cap account for 19% of the total index market cap, 20% of the total index earnings and also have the lowest P/E ratio of the three categories. The top 50 companies account for about 50% of the index market cap and earnings and have a slightly higher P/E ratio than the top 10 group. Finally, the bottom 450 companies account for about 50% of the index market cap and earnings and have a much higher P/E ratio than the first two groups.

From here it's easy to see how the largest companies in the index can distort index level statistics like P/E and give the impression that stocks are in general fairly valued. In fact, stocks, in general, appear to be richly valued, while some stocks (the largest 10 percent to be precise) are the cheapest of the bunch. In the second table below we group each company in the S&P 500 into declie bins based on market capitalization (i.e. each bin contains 50 companies with bin 1 containing the largest companies by market cap and bin 10 containing the smallest companies by market cap). Companies in decile 1 are far cheaper, at least according to forward P/E ratio, than companies in any other decile.

In conclusion, it may be true that the market P/E ratio is average based on only the last 15 years of history (chart below), but this statistic is greatly skewed by a few mega-cap companies sporting by far the lowest P/E ratios of any other group of companies. In fact, the smallest 450 companies in the S&P 500 that makeup only 50% of the market capitalization of the index have a forward P/E ratio that is more than 4 points higher than the largest 50 companies in the index. Furthermore, while the current market forward P/E ratio is average, we must remember that included in that average is a long period in which valuation levels were by any standard in "bubble" territory.

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Gavekal Capital is a US registered investment advisory firm that manages the Gavekal Knowledge Leaders Strategy. Knowledge Leaders are a group of the world’s leading innovators with deep reservoirs of intangible capital. These companies often possess competitive advantages such as strong brand, proprietary knowledge or a unique distribution mechanism. Knowledge Leaders are largely service-based and advanced manufacturing businesses, often operating globally. Gavekal Capital seeks to identify the world’s leading knowledge companies through a proprietary process that analyzes corporate knowledge investments.
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