The Best-Valued Stocks are Not Always Large-Cap Companies

May 19, 2022

Source: Bloomberg Source: Bloomberg

U.S. stocks are off to a rough start this year. To date, the S&P 500 Index has posted its second-worst beginning to a year in history. Understandably, there has been a lot of valuation contraction across many indexes. One way to value a company’s stock as being cheap or expensive is the ratio of its share price to its earnings (P/E). As a value investor, I identify stocks that appear to be trading for less than what they are worth. A low P/E multiple is one potential indicator of such stocks.

This week's chart shows forward P/E ratios of the S&P 500 (large cap), S&P 400 (mid cap) and S&P 600 (small cap) Indexes. Forward P/E ratio is the current share price divided by the estimated future earnings of the companies in each index for the next 12 months. Of note, as of May 16, the S&P 500 Index is trading at 17.6x. Since the 2020 COVID-19 lows, the stock market has experienced extreme multiple expansion and now contraction in a very short period of time. Although the forward P/E for the S&P 500 Index is lower than in 2020 and 2021, it is still elevated compared to historic multiples and implies that many of the underlying stocks in the index remain relatively expensive.

However, the decline in valuations has not been the same across market capitalizations. As seen in this week’s chart, stocks in the S&P 400 and S&P 600 Indexes, representing the mid-capitalization and small-capitalization segments of the U.S. equity market, have declined even faster. These indexes look much cheaper than the S&P 500 Index, as evidenced by their lower forward P/E ratios of 12.9x and 12.8x, respectively.

Key Takeaway

For now, it appears that small-cap and mid-cap stocks are presenting more value relative to their large-cap peers. This could present buying opportunities, as they seem relatively inexpensive. Some income strategies, however, are unable to capture this valuation disparity as they focus on large-cap dividend payers only. An all-capitalization strategy with the flexibility to invest in a variety of market-cap companies could potentially take advantage of these types of valuation differences and add value. Identifying quality companies with solid and sustainable earnings, no matter the underlying market capitalization, is key. The best-valued stocks are not always large-cap companies and having the ability to buy across the market-cap spectrum can be beneficial.

Tags: large-cap stocks | S&P 500 Index | mid-cap stocks | P/E ratio | COVID-19 | small-cap stocks | S&P 400 Index | S&P 600 Index

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