A Valuation Exercise For The Mag 7
The Magnificent Seven continue to pull the market ahead. Are their valuations justified?
Today, we’re exploring the valuations of the world’s biggest companies and what they mean.
As most are aware, markets have heavily favored U.S. large caps in recent years, especially the so-called “Magnificent Seven”—Alphabet, Amazon, Apple, Meta Platforms, Microsoft, NVIDIA, and Tesla.
These stocks have dominated the S&P 500, driving a huge share of its gains. At this point, investing in the index is for a large part investing in just seven companies.
Over the past five years, the S&P 500 is up 86%, while the STOXX 600 has gained just 30% and the Russell 2000, 40%. The Nasdaq—where the Mag 7 have an even bigger weight—has surged over 111%.
The point is, it’s getting harder and harder to find value in U.S. large caps. My own portfolio (unintentionally) reflects this. Right now, my only U.S. holdings are Amazon, Airbnb, MSCI, and Salesforce, with more than half of my portfolio allocated to Europe.
I’m not here to make macro predictions (I don’t like anything macro), but I will urge you to look beyond U.S. large caps. There are plenty of opportunities in overlooked markets—you just have to turn more rocks.
The Mag 7’s Valuation
The fact that the Magnificent Seven have largely carried the S&P 500 and Nasdaq doesn’t automatically mean they’re wildly overvalued. These companies dominate for a reason—they’re the best in the world.
But it is clear that we’re reaching a point where investors need to be cautious when investing in them, and by extension, in the S&P 500 and Nasdaq.
Let’s take a quick look at their valuations to highlight why most might not be great bets right now. Don’t take this too seriously—think of it as a thought experiment.
Alphabet
For each of these companies, we’ll assume 12% free cash growth for the next 20 years, with a 2.5% terminal growth rate. That’s a very optimistic assumption for most, given the natural slowdown in growth over time, especially at their sizes. But that actually helps prove the point—if even optimistic inputs result in mediocre returns, the reality would be even worse.
Alphabet’s 2023 free cash flow was $55 billion. Using our assumptions, this implies an annual return of 10.3%. Not bad, but not great when considering how optimistic our growth estimate is.
Amazon
Amazon is my largest holding, so you might wonder—why say the Mag 7 might be overvalued if I own one?
Well, this same thought-experiment gives Amazon an even lower expected return of 6.7%. But this requires some nuance. Amazon’s 2023 free cash flow was very low, and 2024 is expected to be much higher. More importantly, Amazon reinvests heavily in capex and R&D, which suppresses current free cash flow in exchange for higher expected cash flows down the road.
For Amazon, it might make more sense to use operating cash flow instead. Even that doesn’t fully capture the picture, since a lot of R&D is expensed rather than capitalized.
Either way, using operating cash flow instead of free cash flow gives an implied return of 11.8%—solid, but still not great given our bullish assumptions.
I realize I’ll need to break this down further and explain my thesis in detail in a future post.
Apple
Applying this thought experiment to Apple is probably the most unrealistic, since Apple isn’t really growing at double-digit rates anymore (at least for now).
An implied return of 11.9% looks great, but it assumes Apple will generate over a trillion dollars in free cash flow in 20 years—not gonna happen.
A more reasonable assumption might be 5% annual cash flow growth, which drops the expected return to 7.1%.
Meta Platforms
Meta is no exception, with an implied return of just 8.1% if free cash flow grows 12% annually for 20 years.
Unlike some of the other Mag 7 companies, however, I can actually see Meta pulling this off. But it’s still an assumption I wouldn’t be too comfortable with, and, besides, 8.1% is not enough.
Microsoft
Microsoft’s fiscal 2024 free cash flow was $74 billion, excluding the Activision Blizzard acquisition. Applying the same growth assumption leads to an okay 10% implied return.
Microsoft has plenty of ways to keep compounding free cash flow, but I don’t really see this kind of growth sustain.
NVIDIA
NVIDIA is tricky because of its current explosive growth, but again, this thought experiment isn’t meant to be realistic.
I’ll use fiscal 2025 (which ends this January) numbers as the base year, though keep in mind these are mostly analyst estimates.
Assuming 12% free cash flow growth for the next 20 years results in an implied return of 10.5%.
Tesla
Finally, there’s Tesla. This experiment results in complete garbage for Tesla, since its free cash flow is close to zero.
Tesla’s thesis depends on explosive free cash flow growth in the future, which I’m not even gonna attempt to forecast.
Where Else To Look?
While this whole exercise was intentionally unrealistic, I hope it makes one thing clear—the Mag 7 might not be trading at attractive valuations right now. Even with unrealistically optimistic assumptions, implied returns aren’t strong. And it’s not just these seven companies. Many other large U.S. companies seem overvalued as well.
Think Netlix. Think Costco. Think FICO.
My advice is: expand your investment universe. Turn over more rocks.
There are plenty of ways to find new stocks. A great place to start is Substack itself, where many writers (myself included) pitch their best ideas.
Other options? Screeners (though I don’t love them), your network (be carefully not to listen to your uncle at the family party), and super-investors.
The point is—there’s value out there, but you’ll have to look beyond the obvious names.
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Disclaimer: the information provided is for informational purposes only and should not be considered as financial advice. I am not a financial advisor, and nothing on this platform should be construed as personalized financial advice. All investment decisions should be made based on your own research.