What are we looking for?
Today, we are taking a deeper look at the 12 most pricey stocks of the S&P 500. Our goal is to determine whether the hefty premiums carried by these stocks are justifiable or not by looking at their economic performance and growth.
The screen
We screened the S&P 500 universe of stocks for the 12 companies with the highest future-growth-value-to-market-value ratio. FGV/MV represents, in percentage, the portion of the market value that exceeds the company's current operating value. The higher the number, the higher the baked-in premium for expected growth and the higher the risk. A negative number reflects a discount. For example, a future growth value of minus 50 per cent means that the market value would need to increase by 50 per cent to equal what the company is worth if its operating profit stays flat forever.
To analyze the stocks, we added the following metrics to our table:
- The economic performance index, or EPI (return on capital divided by cost of capital). An EPI ratio of one or more indicates a company’s capacity to create wealth for its shareholders (a higher EPI displays a greater rate of wealth creation). A number lower than one means the company destroys shareholders’ wealth;
- The return on capital and 12-month change in return on capital;
- The one-year sales change;
- The free-cash-flow-to-capital ratio. This ratio gives a sense of how well the company uses the invested capital to generate free cash flows, which could be used to stimulate growth, pay and/or increase dividends, reduce debt, etc. A positive figure is good, 5 per cent and above is excellent.
The stock price and dividend yield are displayed for informational purposes.
More about StockPointer
StockPointer is a fundamental analysis tool based on an EVA (economic value-added) model to quickly and easily identify investment opportunities. In addition to providing detailed reports on more than 7,500 companies (Canadian stocks, U.S. stocks and American depositary receipts), StockPointer also allows investors to create personalized filters and build custom portfolios.
What did we find?
Not surprisingly, many of the companies in our list are well-known, high performing stocks that have made huge gains in the past years. Nvidia Corp., Align Technology and Adobe Systems Inc. are probably the most solid names in the group in terms of economic performance and general "quality": their EPIs are the highest on the list; their returns on capital are impressive; they reported strong sales growth in the past year; and they all generate positive and high free cash-flows.
Other companies, such as Incyte Corp. and Autodesk Inc., present red flags. Those two have an EPI below one, a low and, at least in the case of Autodesk, decreasing return on capital, and both generate negative free cash-flows. Meanwhile, you still must pay a FGV/MV premium of more than 90 per cent for these two stocks. In other words, their current operating value can only justify 10 per cent or less of the enterprise value. Paying that kind of premium for any company is always risky, but it can work as long as the company continues to grow and report strong results. If growth decelerates or if the company announces lower-than-expected results, be ready for some volatility.
On the other hand, stocks carrying huge premiums while seeing a decrease in return on capital as well as the destruction of shareholder wealth (an EPI figure less than one) should be avoided, or held in very small proportions. As a reference, the average S&P 500 FGV premium is 35 per cent. If you think the market in general is on the expensive side (and it is), keep in mind many of these 12 stocks are about three times more expensive.
Investors are advised to do additional research prior to investing in any of the companies mentioned.
Jean-Didier Lapointe is a financial analyst at Inovestor Inc.