Financial Planning & Wealth Management

The Rise of the Intangibles

A P/E ratio or Price to Earnings ratio is just a ratio that gives us a sense of whether a company is expensive or not. It’s not perfect, but it is still a useful data point to compare where we are today compared with the past.

 

With that in mind, the chart below shows the forward P/E ratio of the MSCI World Index. 

As you can see, the current P/E ratio sits well above its historical average. This clearly indicates a potentially expensive market. Historically, expensive markets tend to deliver lower returns (we want to buy low, not high), which then raises concerns about future performance.

 

It’s no secret that a small group of technology companies have driven much of the market’s recent growth. When we remove these companies – Apple, Google, Microsoft, Facebook, Nvidia, Tesla and Amazon – the “Magnificent 7” – from the equation, the P/E ratio returns closer to historical averages. This suggests that these tech giants may be a key factor in the overall market’s current ‘expensive’ valuation.

One might conclude that these technology companies are way overpriced, and the next 10 years could see some significantly lower returns.

 

However, there’s something fundamentally different about these “New World” tech companies compared to

 “Old World” companies. Old World companies, prevalent in European and South African markets, have very tangible assets – factories, capital equipment, manufacturing facilities, balance sheets, etc. These are the banks, insurers, brick-and-mortar retailers, property companies, and resource and energy companies.

 

Their assets are quantifiable, making traditional valuation methods like P/E ratios well-suited for assessing their worth. An accountant can readily add up all the equipment, labor costs, and other tangible assets to arrive at a fair price.

 

New World companies, on the other hand, are a different breed. Their value lies in the intangibles – cutting-edge software, sophisticated AI algorithms, and a global network of data centers. These assets are remarkably scalable and hold immense potential for user growth. The challenge? These intangibles are not easily quantified.

 

How do you put a value on an AI algorithm or Google’s search engine? The assets of these companies are the software engineers building code that can scale to billions of users or the trillions of data points stored in the cloud.

 

I watched a recent interview with Jeff Bezos where he spoke about use of metrics and proxies, and the dangers that occur when, over time, the connection between the metric and the underlying truth weakens. He said that at Amazon they were constantly evaluating metrics to ensure they were relevant and adaptable to evolving circumstances.

 

It made me think of the intangible assets of the tech companies and how it’s virtually impossible to accurately measure them. The traditional metrics we use can’t capture them. 

 

The rise of the intangibles presents a fascinating challenge for investors. While traditional metrics still hold value, understanding their limitations and being open to innovative valuation methods is going to be critical to navigating the evolving market landscape.

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About

 MattFin is a blog that focuses on wealth management, investments, financial markets and investor psychology. I build financial plans and portfolios for families and individuals

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