“The Calculus of Value” was the title of a recent podcast episode that I listened to by a reputable investor, Howard Marks. I’ve included a link to the episode for anyone who cares to nerd out on investing.
For the rest of you, I’ll summarize the key takeaways below.
“Value” is a subjective term and can be defined in a variety of ways. For some people, the feeling that they got a good “deal” is the primary factor. For others, the quality of a product or the service they received is of greater importance.
Ultimately, the value equation comes down to – What You Get > What You Paid
One of the main variables that influences our perception of value is our expectations.
An analogy I like to give is going to a restaurant for a steak dinner. You would expect to have a better dining experience at a Michelin star restaurant than you would at the neighborhood Applebees. Your expectations are that the food, service, ambience will all be at a premium at the Michelin star restaurant compared to a national chain. Also, you would expect to pay a higher price for that premium experience. If the dining experience matches what you expected for that price, then everyone’s happy. It feels like you received a good value.
What happens if the steak at the Michelin star restaurant is overcooked? Or if you’re waiting for your meal for over an hour?
Those things may not bother you as much when you’re at Applebees, but it feels like a major letdown when you’re anticipating a premium dining experience.
When there is a misalignment of what you expect to receive and what you actually receive, that’s often when we feel most dissatisfied and that you didn’t receive a good value.
As a result, you are more likely to avoid going back to that restaurant in the future. Maybe you even leave a negative review on Google or Yelp.
The same concept applies to investing.
“Growth” stocks, defined as companies that have a high price relative to the revenues / profits they produce, are the Michelin star restaurant in my above analogy. All is well as long as growth matches investor expectations. BUT… if growth fails to at least match or exceed investor expectations, the stock price suffers.
The darling of the S&P 500 and the most talked about public company has been Nvidia. The stock performance has been remarkable and there is no doubt that Nvidia is an exceptional company.
As the company has developed the reputation as the leader in AI, the only thing more insane than the historical stock performance is investor expectations for the future.
The chart above shows that analysts expect Nvidia to generate $110 billion of quarterly revenue and $55 billion of net profits, by the end of the decade. For context, that is more than double its most recent quarter results.
Could it happen? It’s possible and I wouldn’t bet against it. A lot can happen over the next five years though. With any nascent technology, there are still a lot of questions on how things will play out in the future. Some investors believe a second mover advantage exists in AI.
Flashback to January when news came out that DeepSeek released a new open-source model that was competitive with the models of the U.S. leaders for a fraction of the costs. Nvidia’s stock price declined nearly 20% in a week (other big tech stocks were also hit hard).
Over recent years, big tech has been the profitability golden child of America. The bar has been high for an extended period of time (i.e. high valuations), and the largest tech companies have proven they can meet that high bar. As a result, these companies have added trillions of dollars of market capitalization over recent years as their stock prices have risen at a faster rate than the rest of the companies in the stock market. As their stock prices have compounded at an exceedingly fast pace, so too, have the expectations that these companies will continue their track record of exceeding their growth targets.
The bar is exceedingly high for tech companies (see Nvidia above). S&P 500 tech companies made up about 23% of the total first-quarter index profits, yet their shares accounted for about 33% of the S&P 500’s value at the end of Q2. To close that gap, tech profits would have to grow 40%, or tech stocks would have to drop 29% from their end-of-June levels.
While tech has been the dominant sector over the past decade, the entire S&P 500 index is currently trading at an elevated level. The chart below shows the historical Price / Sales ratio of the S&P 500 going back to 1947. There are a variety of valuation metrics you can evaluate, some are easier to manipulate by accounting practices (Price / Earnings or Price / Book Value), but sales are sales.
The previous all-time high (P/S) ratio was 3.41 at the peak of the internet bubble. Today, we’re currently around 3.38. There is certainly a case to be made that sales are much more robust today than they were in the late 1990s (recurring revenue of software subscriptions was not as popular in the early days of the internet), however, the take-away should be that investor expectations are relatively high based on the price they are currently willing to pay for stocks.
High Prices ≠ Market Crash. The stock market has and can continue to trade at elevated prices for an extended period of time, which is why I believe it’s so important to stay invested and not attempt to time the market. However, it is also important to know where things stand today and to set realistic expectations for the future. I plan to publish Part 2 of this newsletter later this week to share more about expectations for the future.
Whether it’s dinner at a fancy restaurant or your investments, expectations are one of the primary drivers of your perceived value. Just like you’re disappointed when a premium dining experience doesn’t meet your personal expectations, the collective “market” also can be very unforgiving to a company who fails to meet growth expectations. Especially, if a stock is priced for perfection.