Tech Stocks Get Cheaper Even as Earnings Stay Strong
Key Takeaways
- •The valuation premium for technology stocks over the S&P 500 has narrowed from roughly 35% to approximately 10% over the past year based on forward price-to-earnings ratios.
- •The Federal Reserve's aggressive monetary tightening cycle has significantly contributed to the compression of technology stock valuations.
- •Corporate earnings in the technology sector remain strong, characterized by robust sales growth and expanding profit margins.
- •Future earnings sustainability hinges on whether substantial capital expenditures in AI infrastructure will generate proportionate revenue growth.
Technology stocks are becoming noticeably cheaper for investors, even as corporate earnings in the sector continue to hold up.
A year ago, investors paid roughly 35% more for a dollar of expected tech-sector earnings than for a dollar of S&P 500 earnings. Today, that premium has narrowed to approximately 10%.
That comparison is derived from forward price-to-earnings ratios, or forward P/E — the price investors pay today relative to the profits that Wall Street analysts expect companies to generate over the coming year.
The development is encouraging for equity investors, though with an important caveat: a lower valuation is only beneficial if the underlying earnings being priced in actually materialize. Thus far, they have.
A Longer Historical View
The narrowing premium looks less unusual when placed in a broader context. For years following the 2008 financial crisis, the technology sector and the broader market traded at broadly similar forward P/E multiples. FactSet noted in 2018 that the average multiples over the prior nine years were nearly identical, before tech valuations began pulling ahead in 2017.
There were sound fundamental reasons investors began paying more. The shift toward cloud computing during the 2010s delivered many technology companies faster revenue growth, recurring income streams, and wider margins. More recently, the AI infrastructure build-out has triggered another substantial wave of capital spending and business expansion.
The COVID-19 pandemic further widened the valuation gap as investors sought exposure to businesses tied to an accelerating digital economy. By December 2020, the tech sector traded at roughly 26.4 times expected earnings, compared with about 22 times for the S&P 500.
The premium compression that followed coincided with the Federal Reserve's most aggressive monetary tightening cycle in decades. Rising interest rates reduce the present value of future earnings growth, a mathematical relationship that tends to weigh more heavily on higher-growth sectors — even when their underlying businesses remain profitable.
Earnings Remain the Foundation
Much of that excess valuation has since been compressed, while corporate profits continue to climb. In his TKer newsletter, Sam Ro has long maintained that earnings and expectations for earnings growth are the most significant long-term drivers of stock prices.
Ro's August 6 note pointed to robust sales growth, expanding profit margins, and rising earnings estimates as evidence that the underlying business environment remains strong. The result: technology investors are now paying a far smaller premium for an earnings stream that continues to deliver.
Whether that earnings stream continues to hold up will depend in part on the return on the capital being deployed into AI infrastructure. The largest technology companies have significantly increased their capital expenditures, and a key question for the sector is whether those investments generate proportionate revenue growth over time.
Ro also cited Truist's Keith Lerner, who summarized the dynamic succinctly: "Earnings continue to underpin equities."
Reporting by Jared Blikre, global markets and data editor for Yahoo Finance. Follow him on X @SPYJared.
