Growth companies shown to be expensive
Share markets have rallied hard over the last 12 months. How do we keep that in context?
If you invest in global shares then you become a part owner of those businesses, meaning part of the profits those businesses earn belongs to you; a proven path to wealth creation. This concept is nicely captured by return on equity – net profit divided by the market value of the business. If a business earns $10 and it is valued at $100 then the return on equity is 10%.
As the graph above shows the return on equity available from growth and value shares respectively is around 8.3% and 17% respectively from what MSCI regards as ‘value’ and ‘growth’ companies. There is a dispersion in those rates of growth, however as the graph demonstrates, that dispersion is not unusually significant relative to history.
A second question then becomes relative value. If ‘growth’ companies are offering me a better return on equity capital then I would be happy to pay more – this is rational, growth means I expect more cash generation in the future and that is valuable.
Our second graph also focuses on earnings, so we have consistency with our earlier return on equity graph. What this second graph shows is how many times the current earning we have pay to purchase a piece of a business – the Price divided by Earnings Ratio (or ‘PE Ratio’).
At present the average cost of a MSCI designated ‘value’ company is 22.4 times its earnings. For ‘growth’ companies the average cost is 42.7 times earnings. This means that at present ‘growth’ companies are nearly twice as expensive as value companies. This relative expense of growth has deviated significantly from what we would normally expect, meaning growth companies are currently very expensive on a relative basis.
We all need and want our investment capital to grow. If you have overpaid for an investment then either that business needs to grow into its valuation, or alternatively the share price is going to adjust back down towards fair value leaving you with unrealised losses in the near term.
Investing in companies that grow is rational, when the valuation is appropriate.