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Implied Expectations in US Megacaps: Q1 Earnings Season Preview

In preparation for the upcoming earnings releases for US megacap stocks over the next two weeks, Applied Finance would like to take inventory of the intrinsic value and implied expectations characteristics of the short list of stocks that comprise more than 25% of the S&P 500.

Due to the impact that these stocks have on cap-weighted benchmarks, we review their valuation prospects on a quarterly basis. Many investors presume that these stocks are all due to underperform solely based on either their large market caps, expensive GAAP accounting-based price multiples or high rates of investment. Applied Finance can better identify each firm’s investment prospects and potential impact on equity benchmarks by studying intrinsic value characteristics through a comprehensive valuation framework that incorporates economic profitability, growth, competition, and risk.

An important driver this earnings season is the broad investor focus on the impact of potential interest rate hikes on asset values. While investors are wise to consider cost of capital in a comprehensive intrinsic value framework, the real US market-derived discount rate currently used in Applied Finance’s valuation model is 64 bps higher (4.96%) than the level assumed at the end of 2018 (4.32%) when the yield on 10-Year treasuries was 2.8%. From this perspective, we can comfortably assume that 4-5 interest rate hikes at 25bps each over the next two years are likely already “priced in” to these profitable megacap stocks. Higher cost of capital is still a significant concern for unprofitable firms that rely on external financing, but most of the megacap stocks we will review today can access external financing at rates comparable to risk-free assets to either repurchase shares or invest in positive NPV opportunities.

Alongside interest rates, investors would be wise to focus on the structural rise in profitability for US firms, led by the megacap stocks we will review today. It is a fair debate whether these higher profit margins are sustainable. Many investors prefer to assume that recent record profit levels are simply a function of stimulus and loose monetary policy; therefore, they will quickly be competed away and converge towards historical averages. Others acknowledge that network effects and accelerated digitization over the last few years has further strengthened the competitive advantages of the largest, most profitable firms. If profits fade for the select megacaps we will review today, the impact on broad market indices would be significant due to the aggregate weights these stocks hold in US markets. At the same time, if recent margins are sustainable, it’s possible that the early 2022 sell-off in US markets is unwarranted.

Recent Performance of US Megacaps

The five largest stocks (AAPL, MSFT, GOOGL, AMZN, FB) led US market returns in Q4, gaining 13.3% on a cap-weight basis vs. 7.9% for all other Russell 3000 constituents. In 2021, these five largest stocks gained 35.3% while all other Russell 3000 stocks gained 23.4%. By mid-October, TSLA surpassed FB as the fifth largest stock and continues to remain in the top 5 at year end.

At the start of 2022, the top 5 US stocks by market cap (AAPL, MSFT, GOOGL, AMZN, TSLA) now represent 23.6% of the S&P 500’s total market cap. Following the reconstitution at year end, the 5 largest US stocks have sold off by -10.9% year-to-date through 1/24, while all other US stocks have declined by 7.3%.

Intrinsic Value Trends of 5 Largest S&P 500 Stocks

Due to Q4 appreciation of AAPL/MSFT and inclusion of TSLA, the intrinsic value upside of the top 5 megacaps has fallen from 19.1% on 9/30/21 to -15.1% as of 12/31/21. It was useful in 2021 to acknowledge the compelling intrinsic value levels of these megacap stocks as they propelled overall market returns higher. While we no longer observed significant upside as of the end of 2021, it’s worth noting that current intrinsic value levels are nowhere near tech bubble levels of -49.9% observed at the start of 2000. The recent sell-off since year end has likely pushed these default intrinsic value upside levels to -5%, all else equal. Next quarter’s update may also change dramatically, as it will include 2021 annual reports for GOOG, AMZN, TSLA and FB which will fully capture the strong revenue growth and margin improvement already delivered through 2021 Q3.

Intrinsic Value Trends of FAAMG Stocks

FAAMG stocks contribute 23.3% of the S&P 500’s total market cap, 21.7% of intrinsic value (based on LFY financial statement data), 7.8% of book value, and 26.7% of intrinsic value in excess of book value. We have excluded TSLA, as their market value at this point is almost entirely derived from future growth and profitability improvements.

Further incorporating forecast data into our intrinsic value analysis will allow us to compare consensus estimates against the implied expectations embedded in each firm’s stock price at the end of 2021. This is especially important for GOOGL, AMZN, TSLA and FB due to their massive EPS and revenue growth expectations.

Apple Inc (AAPL) Intrinsic Value Contribution & Implied Expectations

AAPL contributes 6.8% of the S&P 500’s total market cap, 6.5% of intrinsic value (based on LFY financial statement data), 0.8% of book value, and 8.6% of intrinsic value in excess of book value. The recent jump in intrinsic value contribution is partially due to AAPL’s September fiscal year end and will likely normalize in early 2022 once firms with December fiscal year ends report their 2021 results.

Implied sales growth for AAPL from 2022 forward is 6.2%, which is 1.0% higher than consensus 2022 forecasts of 5.2%. In 2021, AAPL’s EBITDA Margins increased by more than 400 bps. Economic Margins jumped from 12.4% to 21.4%, their highest level since 2012. Due to substantially higher Economic Margins, AAPL’s Economic Profit Horizon has fallen from 26 years in 2019 to 20 years now.

While higher margins are typically difficult to maintain due to lower returns on incremental investment and increased competition, AAPL’s recent increase in economic profitability is due to the expansion of their higher margin service segment, as well as substantial increases in revenue and cash flow despite minimal change in invested capital. It would be prudent to first confirm that AAPL will be able to sustain these higher margins despite the strength of their competitive advantages. If it is deemed reasonable to assume an above average Economic Profit Horizon of 24 years, implied sales growth falls to -1.6%.

Microsoft Corp (MSFT) Intrinsic Value Contribution & Implied Expectations

MSFT contributes 5.6% of the S&P 500’s total market cap, 5.2% of intrinsic value (based on LFY financial statement data), 1.7% of book value, and 6.4% of intrinsic value in excess of book value. Similar to AAPL, the recent jump in valuation contribution is partially due to MSFT’s June fiscal year end and will likely normalize in early 2022 once firms with December fiscal year ends report their 2021 results.

Implied sales growth for MSFT from 2022 forward is 12.1%, which is 3.9% lower than consensus 2022 forecasts of 16.0%. In 2021, MSFT’s EBITDA Margins increased by 280 bps, followed by an additional 250 bps jump in 2022 Q1. Economic Margins improved from 12.7% to 15.0% in 2021, their highest level since 2012. Mildly higher EMs coincide with a mild drop in their Economic Profit Horizon from 27 years in 2019 to 25 years now.

Due diligence in the AAPL example led us to consider an adjustment to the default Economic Profit Horizon (given that a 20-year period is “average” for Russell 1000 firms and understates the competitive advantages and network effects that these megacap firms have developed). For MSFT, it is reasonable to accept the slightly lower profit horizon of 25 years as it continues to reflect above-average levels compared to other Russell 1000 firms.

Alphabet Inc. (GOOGL) Intrinsic Value Contribution & Implied Expectations

GOOGL contributes 4.5% of the S&P 500’s total market cap, 3.8% of intrinsic value (based on LFY financial statement data), 2.7% of book value, and 4.1% of intrinsic value in excess of book value. Through 2021 Q3, GOOGL has delivered significant gains in revenue and margins which indicate that these valuation contributions should increase once financial statement data from their next annual report is filed.

Implied sales growth for GOOGL from 2022 forward is 0.5%, which is 16.4% lower than consensus 2022 forecasts of 16.9%. R4Q EBITDA Margins through 2021 Q3 are nearly 10% higher than R4Q levels as of 2020 Q3. Based on 2021 forecasts, GOOGL’s Economic Margins are expected to improve from 7.8% to nearly 15%, which would be the highest level since 2007. Meanwhile, their Economic Profit Horizon has fallen from 25 years in 2019 to 21 years now.

It will be important for investors to monitor the sustainability of GOOGL’s recent levels of higher profitability, but this decision does not alter an investment thesis formed on implied expectations. Implied sales are already significantly below consensus forecasts using a 21-year Economic Profit Horizon. If investors believe it is prudent to assume a longer than “average” profit horizon, GOOGL’s implied sales growth falls to -4.7% when a 24-year horizon is assumed.

Amazon.com Inc (AMZN) Intrinsic Value Contribution & Implied Expectations

AMZN contributes 3.9% of the S&P 500’s total market cap, 2.2% of intrinsic value (based on LFY financial statement data), 1.1% of book value, and 2.6% of intrinsic value in excess of book value.

Implied sales growth for AMZN from 2022 forward is 9.8%, which is 7.6% lower than consensus 2022 forecasts of 17.3%. R4Q EBITDA Margins through 2021 Q3 are only 100 bps higher than R4Q levels as of 2020 Q3. Based on 2021 forecasts, AMZN’s Economic Margins are anticipated to be comparable to 2020 levels of 6.7%. Recent margin stability has elevated AMZN’s Economic Profit Horizon from 25 years in 2019 to 27 years now.

In case investors are concerned about AMZN’s elevated Economic Profit Horizon compared to other megacap firms studied in this format, we can adjust the horizon to 24 years and note that implied sales increase to 11.8% from 2022 forward, which is still 5.5% below consensus forecasts.

Tesla Inc. (TSLA) Intrinsic Value Contribution & Implied Expectations

TSLA contributes 2.5% of the S&P 500’s total market cap, 0.1% of intrinsic value (based on LFY financial statement data), 0.3% of book value, and 0.1% of intrinsic value in excess of book value. Through 2021 Q3, TSLA has delivered significant revenue and EBITDA expansion; their valuation contribution should increase once 2021 full year data is available. Unlike other megacap stocks reviewed here, nearly all of TSLA’s market value is derived from forecasts that assume significant growth and margin improvement. Due to this, we will adjust our implied expectations to incorporate consensus revenue forecasts and solve for the implied EBITDA margin required to derive TSLA’s current market price.

In our first model, implied sales growth for TSLA from 2022 forward is 68.3%, which is 23.5% higher than consensus 2022 forecasts of 44.8%. R4Q EBITDA Margins through 2021 Q3 are 175 bps higher than R4Q levels as of 2020 Q3. This analysis also includes a revision of the Economic Profit Horizon from 16 years to 24 years to attempt to capture competitive advantages TSLA has potentially built in their loyal customer base and technology but not reflected by the inputs in default profit horizon assumptions. (Without this adjustment, implied expectations will not provide any meaningful insight that adequately align fundamental forecasts to current market prices.)

The bull case for TSLA assumes continued margin improvement on top of massive revenue growth. (In Q3, EBITDA margins reached 20.5%) Using consensus sales forecasts, we can instead solve for implied EBITDA margins, which are 21.4% from 2022 forward.

Reconciliation of TSLA’s stock price to intrinsic value requires continued margin expansion, despite the increased competition in the EV space, alongside significant revenue growth. Some investors believe they will achieve these forecasts, while others believe margins will converge to levels delivered by legacy automakers and rising competition should put downward pressure on their Economic Profit Horizon. Either way, this analysis simply provides a sense of the revenue growth, margin expansion and profit horizon embedded in TSLA’s current market price.

Meta Platforms, Inc (FB) Intrinsic Value Contribution & Implied Expectations

FB contributes 2.2% of the S&P 500’s total market cap, 4.0% of intrinsic value (based on LFY financial statement data), 1.5% of book value, and 4.9% of intrinsic value in excess of book value. Through 2021 Q3, FB has delivered significant gains in revenue and margins which indicate that these valuation contributions should increase once financial statement data from their next annual report is filed.

Implied sales growth for FB from 2022 forward is -11.0%, which is 29.2% lower than consensus 2022 forecasts of 18.1%. R4Q EBITDA Margins through 2021 Q3 are 400 bps higher than R4Q levels as of 2020 Q3. Based on 2021 forecasts, FB’s Economic Margins are expected to increase from 15.2% to nearly 17%. FB’s Economic Profit Horizon has also mildly improved from 23 years in 2019 to 24 years now.

FB’s recent announcement that they plan on spending significant levels of capex on investment in the metaverse will have a material impact on future cash flows. High levels of free cash flow had been used on share repurchases that lowered outstanding shares from 2.91B at the end of 2017 to 2.79B through the end of 2021 Q3; much of this excess cash flow will now likely be routed towards capex instead. The success of this initiative plays a material role in determining if FB will be able to sustain high levels of economic profitability over this 24-year profit horizon.

Implied Expectations Summary

If US megacap stocks can maintain recent profit levels, they appear to trade at prices that reflect reasonable expectations. (Only TSLA requires a speculative adjustment to their Economic Profit Horizon to reconcile current market prices to fundamental forecasts.) This not only bodes well for the investment prospects of each firm, but it also provides support for the overall US market that is heavily influenced by the aggregate contribution of the market cap weights of these stocks. We look forward to providing further updates in Q2 once full year 2021 data is available for GOOGL, AMZN, TSLA and FB. As we noted earlier, most investors are focused on interest rate signaling that we will learn over the course of this week, but we believe it is equally important to consider the sustainability of recent profit levels for these megacap names. From that perspective, it is critical to monitor new quarterly earnings data, as well as the forward guidance provided by each firm.

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Author

  • Derek Bergen, CFA – Applied Finance Partner  Joined Applied Finance, 2005. Portfolio Manager and Quantitative Research Analyst. B.S. University of Wisconsin-Madison.

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