Are Stocks Overvalued?
Of course stocks are overvalued, but by how much? What about the average company?
I have absolutely no idea how to value Apple, Nvidia, Amazon, Microsoft, Google, Meta, and Tesla (the Magnificent 7). Maybe these are the world’s greatest companies, or maybe it is the “1970’s Nifty Fifty” all over again. Maybe these companies will continue to dominate the world, or maybe all the executives should be sent to an El Salvadoran prison for violating the anti-trust laws. Mindless folks, buying passive funds, have pushed these stocks to silly valuations. The mindless folks are aided and abetted by the so called “professional investors” that are really just momentum traders. Are these 7 stocks 50% overvalued, or just 25% overvalued? I have no idea, take your pick.
I think trying to value market indexes is foolish. First, about 30% of the indexes are the 7 above mentioned companies. Trying to estimate the “E” in the remaining 70% is just too difficult. When someone tries to tell you what the PE of S&P 500 is X, just get up and leave the room. Try to find some sane folks.
A better approach is try to pick a few mega-cap stocks with predictable earnings and clean balance sheets. My two favorites are Colagte-Palmolive - CL - $89, and Illinois Tool Works - ITW - $222. To me these are the ultimate boring mega-cap stocks that represent “the average mega-cap stocks” much better than any index.
Both CL and ITW sell at about 16x EV/EBITDA. That is again just silly, maybe 12x would be more reasonable.
Here is what I wrote in any early post:
I hesitate to value most companies using EBITDA, but I have less of a problem using this method for companies that require few capital expenditures like CL. Here is a very rough method, that I have heard several smart CFO’s advocate over the years for what they are willing to pay for acquisitions:
4x EBITDA for the most troubled of companies
6x EBITDA for average companies
8x EBITDA for solidly above average companies
10x EBITDA for great companies that have deep “moats” around their business
12x EBITDA for the very best of companies
I thinks there are dozens of overvalued mega-caps like CL and ITW, bid up by the mindless passive investors.
I strongly prefer a 3% to 4% T-bill to these mega cap stocks.
But what the average company?
I decided to build my own index of medium size “average companies”. He is my index of slightly above average and strong balance sheet companies:
20% industrials, 20% consumer cyclicals, 20% consumer staples, 20% technology, 10% healthcare, and 10% energy.
Alamo Group - ALG - $162 - everyone should travel to beautiful Seguin, Texas to meet this boring maker of commercial lawn mowers. My ultimate average industrial sells for 9x EV/EBITDA
Gates Industrial - GTES - $16 - they make rubber belts and hoses for auto and industrial applications, 8x EV/EBITDA
Cheesecake Factory - CAKE - $44 - the average restaurant, 12x EV/EBITDA
American Eagle - AEO - $11 - the average retailer, 6x EV/EBITDA
Reynolds Consumer Products - REYN - $22 - the average maker of kitchen products, 9x EV/EBITDA
Spectrum Brands - SPB - $60 - bug spray and George Foreman grills, 7x EV/EBITDA
Arrow Electronics - ARW - $90 - distributor of semiconductor chips, 8x EV/EBITDA
Cirrus Logic - CRUS - $83 - fabless maker of analog semiconductor chips, 9x EV/EBITDA
Henry Schein - HSIC - $64 - distributor of dental supplies, 13x EV/EBITDA
Oceaneering International - OII - $17 - supplier to offshore drillers, 6x EV/EBITDA
These are not my 10 favorite ideas, these are 10 randomly selected, boring but predictable companies I have watched for 25+ years.
These are 10, average to slightly above average, companies with strong balance sheets. The average market cap is about $4 billion. I would call that mid-cap, not small cap.
On average these companies sell at 9x EV/EBITDA, and about 12x 2025 estimated earnings, 2x book value, and 1x EV/sales.
I think I can make the argument that the “average company” is fairly valued in today’s crazy stock market environment.
I get roughly the same average valuations when I look at the portfolios of small or mid-cap value mutual funds.
My conclusion is the mega-caps are still overvalued, and the mid-caps are fairly valued.