Stock Valuations are Sky-High Part 2 - Is more growth possible?
A look at the arguments for and against today's high prices
In my last article, I shared the history of high stock market valuations and what that could mean for near-term returns.
We zoomed out and compared what had happened historically in the 10 years after situations like we see today. It’s a pretty pessimistic outlook.
But that’s all history. Different times with different circumstances. What do we know about the circumstances today?
The reality of the stock market today suggests a cautiously more optimistic outlook. Investors and analysts alike have been pretty confident going into 2025, which has been driving stock prices higher.
I want to examine one key metric behind this optimistic view: growth in earnings per share (EPS).
Understanding earnings per share provides a helpful framework for understanding the market and how analysts make forecasts.
The Power of Earnings Growth
Earnings per share growth is arguably the most important component in forecasting stock prices.
Why? When you buy stock, you pay for the company's future profit, not yesterday's.
Earning per share (EPS) measures how much of that profit belongs to you as a shareholder. When it grows, your portion of that profit grows.
You calculate it by dividing the company’s total net profit by the number of outstanding shares. If a business makes $100 in profit and has 100 shares, each share receives a $1 “slice” of that profit.
Looking backward - We’ve had 9% Annual EPS Growth over the last 5 years.
Over the last five years, US large-cap growth shares have grown their EPS by 9% per year, according to research from Citi Bank.
Many of the biggest companies, especially in the tech and consumer sectors, have consistently increased their profits.
It’s been a good few years for many companies, and some have done astoundingly well. In 2024, Nvidia was the belle of the ball because it had an incredible 80% annual EPS growth in some quarters.
Looking forward - We need to continue having 8–13% EPS Growth to support our stock prices.
Analysts suggest markets need consistent earnings growth of 8% to 13% annually to support current valuations.
If companies continue to deliver on the upper end of that range, today’s valuations might not look so expensive in hindsight because companies' profits will grow into the current stock prices.
When people say that information is already ‘priced into’ the market, this is one example of what they mean.
The logic is that investors believe that earnings per share will grow, so they are willing to pay more now to own that company and own a part of that future growth.
That’s what some analysts and investors are betting on.
Why Some Analysts Say the Market Is Not Overvalued
Optimistic analysts and investors point to a few pieces of evidence that support these high valuations.
Growth trends have been strong.
The 9% annual growth in EPS for large-cap growth shares provides real evidence that many companies have successfully scaled their operations. Businesses that can sustain this growth can justifiably command higher stock prices.
Analysts at the largest financial institutions are crunching the numbers, and many believe that those companies can continue to do so, at least in 2025.
For example, going into 2025, Goldman Sachs predicted 11% EPS Growth.
Innovation and productivity gains are expected to continue as AI adoption expands.
Today, many of the largest companies are innovators in technology and healthcare, which often enjoy economies of scale and winner-takes-most dynamics.
These companies can boost profits quickly by adopting and developing new technology, like AI.
Consumer demand has been remarkably resilient.
While economic conditions can be unpredictable, consumer demand in travel, e-commerce, and digital entertainment has remained surprisingly strong, helping sustain revenue and profit growth.
3. Why Others Insist the Market Is Overvalued
The current aggressive growth expectations mean that many things have to keep going right. And some analysts think this won’t happen, although they seem to be in the minority among the big banks.
High Valuations could be sensitive to even small amounts of bad news.
Traditional measures like the price-to-earnings (P/E) ratio show that many stocks are trading well above their historical norms.
If earnings slip even slightly, these ratios could spike higher still, making prices look even more stretched.
There are some macroeconomic headwinds.
Inflation, potential interest rate hikes, and geopolitical tensions may weigh on corporate profits.
If growth slows in certain sectors, analysts may have to cut forecasts, which could quickly undermine today’s prices.
The economy is vulnerable to global uncertainty.
Whether it’s a sudden tariff spike, political turmoil, oil prices, an unexpected recession, or a global event, markets can correct rapidly if corporate earnings growth looks threatened.
Valuations that rely heavily on future optimism can be more exposed to sudden shifts in sentiment.
4. So, Are We Overvalued—or Not?
It depends on who you ask and how you weigh future growth possibilities against potential risks.
These debates about overvaluation are nothing new—and they often hinge on whether earnings growth can meet (or beat) expectations. This is why understanding earnings gives you a helpful framework for understanding where the market is and how analysts make forecasts.
If earnings grow at >9%, the market’s present valuations may prove reasonable or even cheap in the long run.
But if growth falls below 8%, today’s high prices could look unsustainable.
Today, they tell us that there is a reasonable case that stocks are not overvalued.
However, we also know that high valuations are difficult to sustain over the medium term. They are particularly vulnerable to falling short of expectations, inflation, and global uncertainty.
And what should we do?
As I’ve said in the last article, I have a few pieces of advice for investors right now:
1. Stay the Course and ignore the day-to-day headlines.
Keep investing based on your financial plan and retirement timelines.
Timelines and goals should guide your strategy, not what the market does on any given day.
2. Build or update your financial plan.
If you haven’t thought about it in a while, now is probably a good time to update your financial plan. In particular, you want to ensure your portfolio has an allocation and strategy with an appropriate level of risk to match your goals and timelines.
For example, a fair amount of people have an investing plan that involves simply dumping money into an S&P500 index fund. Honestly, that’s a pretty good general-purpose strategy if your timelines are long and you have the appetite and capacity to take on risk.
But what if you are about to start a family? Or buy a house? Or do you want to retire on the earlier side? Those goals and timelines suggest a different plan. Now is a good time to figure out your plan or get help from an expert to design a plan that fits your unique situation.
3. Adjust Your Expectations and modeling assumptions.
Markets don’t consistently deliver double-digit growth over the medium term and are unlikely to provide anything close to that when valuations are so high. Adjust your mindset and prepare yourself mentally and emotionally.
We might have another good year, but this may not be the decade where you get rich.
4. Stay diversified.
Just as we can’t predict one-year returns on the total stock market, we can’t expect to pick the winners and losers of individual stocks and sectors.
Stay broadly diversified to spread your risk. Ensure you have the right asset classes in the right proportions to match your financial plan.