Important information: The value of investments and the income from them, can go down as well as up, so you may get back less than you invest.

Every quarter, the big US Tech companies report their earnings covering the past three months. Every quarter, industry experts make predictions about those earnings. And every quarter (or the past four, at least) those predictions are ‘comfortably’ beaten.

The ritual serves to remind us just how profitable the last few years have been for America’s biggest companies. Their rising profits have been outpaced only by their soaring stock prices.

When these companies have such a stranglehold on the market, you’d be justified for wondering why anyone still cares about their earnings - surely it’s the price that matters? In fact, it’s precisely because these companies are so big that their earnings receive such attention.

Unlike a share price, which shows how investors value a company, earnings reports tell us how well the company is actually doing - how much profit it makes.

That’s important for any company, for obvious reasons. For the US’ six biggest - Amazon, Apple, Facebook, Tesla, Microsoft and Alphabet (parent company of Google) - it takes on added significance. These companies currently make up around 21% of the total value of the US’ 500 largest. They hold huge sway over its stock market and, by extension, the global market.

As they accumulate more and more value, concern mounts over whether their fundamentals - i.e. the actual businesses that underly the stock prices - can justify their sky-high valuations.

Comparing their stock prices against earnings is one way to gauge that.

A stock’s price will usually be greater than its earnings, owing to the future-facing nature of markets. The S&P 500 for instance, the index of the US’ largest 500 companies, is now trading at 40.9x earnings. By comparison, Amazon is trading at 93.9x earnings. Tesla is 1,267.6x earnings.

That’s a staggering difference. It tells us that investors are willing to pay over 1,000 times Tesla’s worth according to its most recent earnings. And while earnings do not tell the full story - there may be future potential in a stock which isn’t reflected in its P/E ratio - this kind of divergence makes any investment almost entirely speculative. You’re essentially hoping that the company will one day be able to deliver the extreme value you’ve apportioned it. At those prices, that’s a tough ask.

The widening gap between valuations and earnings is one factor many people cite as evidence that we are straying into market ‘bubble’ territory, implying a crash is lurking around the corner, similar to the bubble of 2000. Last week’s frenzied stock trading is another.

However, one key difference between now and 2000 is that the Big Tech companies with the highest valuations appear to have far more fundamental worth than the instigators of 2000’s crash ever did.

Big Tech did well last year not (just) because of wild optimism, but because there was a surge in demand for their services. Companies like Amazon and Microsoft provide the stay-at-home technologies which have kept many businesses and households functioning in extreme circumstances.

That was reflected in their latest round of earnings - Apple delivered its highest ever net profit in the fourth quarter, while Amazon reported its first ever $100 billion quarter - with one notable exception. Tesla, the electric car company that saw its stock price octuple last year, underwhelmed.

Tesla has always been the oddball of the pack. It’s relatively young compared with the others, and its status as a ‘tech’ company seems odd given its reputation as a carmaker. Nevertheless, it’s Tesla’s technological edge over the competition that is thought to justify its ascendancy in recent years.

Make no mistake about it, Tesla is absurdly expensive. It currently has a market cap above $800 billion, making it worth more than the next nine carmakers combined.

And while 2020 was the first year that the company made a profit - $721 million, compared with a loss of $862 million in 2019 - its earnings for the fourth quarter fell below analysts’ expectations. As a result, Tesla’s share price was down about 5% in extended trading following its report.

The company faces wider problems too. Not making a loss is great, but it’s still making far less money than other carmakers. General Motors made about five times in the final quarter of 2020 what Tesla did all year.

Perhaps more concerningly, the technology that served as the foundation - or “moat” - upon which Tesla’s growth was built no longer looks so unique. Most established carmakers are now moving in on electric vehicles. Volkswagen, Renault, Hyundai and others are making cheaper electric cars, some of which are now selling at a faster rate than Tesla’s.

Whatever the wider issues Tesla faces, an underwhelming earnings report serves to remind investors of the value of checking under the bonnet before buying a stock. In a world of ever stretching valuations, fundamentals remain key. The more expensive the price tag, the more solid those fundamentals ought to be. Without them, soaring valuations amount to little more than frothy speculation.

In the case of the six Big Tech companies, the ramifications spread far wider than just those who hold direct investments. These companies dominate the US market and, by extension, many international investors’ portfolios.

Important information: Investors should note that the views expressed may no longer be current and may have already been acted upon. Overseas investments will be affected by movements in currency exchange rates. Reference to specific securities should not be construed as a recommendation to buy or sell these securities and is included for the purposes of illustration only. When you are thinking about investing in shares, it’s generally a good idea to consider holding them alongside other investments in a diversified portfolio of assets. This information is not a personal recommendation for any particular investment. If you are unsure about the suitability of an investment you should speak to an authorised financial adviser.

Topics covered:

Volatility; North America; Shares

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