Why valuations matter, even in tech

The value of your investments and the income you receive from them can go up and down, and you may get back less than you invest. Any examples are for illustration purposes only.

It’s hard to get away from market volatility news at the moment. The S&P 500 slipping into correction territory, after a 10% drop from recent peaks, naturally has the headlines ablaze. Geopolitics aside, it’s a pullback that valuation bugs have been expecting, given the lofty pricetags among the Magnificent Seven tech stocks in particular.

But, if it was all so obvious, how did stocks become ‘overvalued’ in the first place? Is it all just guesswork or is there any value in valuations? Let’s set the scene.

Read more: When should I sell my stocks?

Picture this. You find a new favourite lunch spot (great service, tasty toasties) and bring up its recent share price history. The chart has been rising and one part of you wants to get in because you like how the business is run and see scope for growth. The other part is worried that the chart has already risen and you might be buying at the top. The share price doesn’t tell you much on its own, so how can you figure out whether it’s cheap, reasonable or expensive right now?

As you might have guessed, this is where valuations come in handy. And before we get stuck in - they aren’t complicated and you can normally find them online rather than having to work them out yourself.

The most popular valuation measure, and the one we’ll focus on here, is the price-to-earnings (P/E) ratio - simple but powerful.

It’s calculated by dividing a stock’s price per share by its earnings per share (EPS).

• A high P/E ratio often means investors expect strong future growth from the company. For example, many fast-growing tech stocks have P/E ratios well above 30 or even 50.
• A low P/E ratio can suggest a stock is undervalued or that the company is facing challenges investors are wary of. Some solid companies with stable earnings trade at P/E ratios under 15. Value-seekers tend to get particularly interested in sub-10 levels.

The key takeaway for investors is that valuation metrics, like the P/E ratio, help you understand market expectations. A stock with a sky-high P/E might mean the share price has run away from the actual earnings the company is making. The market might have got too excited with buying its shares - so much so that the earnings will need to seriously impress or that excitement could fade and bring the stock price down. This is where the tech sector has ended up recently, with AI enthusiasm first boosting share prices and the market then seemingly impossible to please, even with record revenues from the likes of NVIDIA.

A low P/E might attract value investors who spend their time looking in other investors’ dustbins for unloved stocks. If they can snap up an undervalued company with solid fundamentals, and see a catalyst for positive change coming soon, they could be onto a winner.

This type of relative valuation measure is arguably most useful when you have other yardsticks to compare it against. How does a stock’s P/E look beside its peers and competitors? What about against its own history? And how does it compare to the index itself? These are all useful questions in getting a better, more rounded picture of the context and how your company fits in. If it’s way out in any of these, ask yourself if there’s a reason for it - maybe exceptional growth prospects, a fundamental shift in how it’s run, or just huge hype.

This all brings us to the recent upheaval in the tech sector, in particular. Setting aside the tariff ping pong, the sector has climbed a wall of worry since Covid really, when investors started to wonder if those high valuations were justified by earnings or if the rise in tech shares had shaky foundations. AI added a further boost, and more worry, into the mix.

Admittedly, huge growth from NVIDIA and pals seemed to add credence to ever-higher share prices but record market concentration (the Mag-7 now make up 30% of the S&P 500) and the market getting less and less dazzled by NVIDIA’s dizzying growth made it all look quite precarious. Throw in valuations like those below and investors started to question whether the previously assumed growth projections were actually reasonable.

Magnificent Seven forward P/E vs the S&P 500 Index

Sources: Yardeni, LSEG datastream. Both classes of Alphabet included, all as at 13 Mar 2025 except 'Magnificent Seven' (7 Mar) and S&P 500 (6 Mar).

The result over the past few months has been a fall in US tech share prices, but where has all that withdrawn money gone? One beneficiary has been Europe. The region sits on a forward P/E of around 14, which has appeared cheap to investors comparing it to the US. The feeling seems to be that, if tariffs don’t hit the region as hard as expected and US tech looks wobbly, current valuation levels might offer a good entry point.

Whether this comes to pass or not is a conversation for another day. The takeaway from all of this is hopefully to give an idea of how you can start to factor in valuations when looking at your current and future investments. If nothing else, they help us question how we look at growth and what we’re prepared to pay for value creation down the line, or when we think it’s time to look elsewhere.

Discrete calendar year performance

As at 13 March 2025. Source: FE Fundinfo. Total return basis, in local currency. Past performance is not a reliable guide to future results.

Sources:

• Yardeni
• LSEG Datastream

Important information

When you invest your capital is at risk. Past performance is not a reliable guide to future returns. Your investments and the income you receive from them may go down as well as up so you may get back less than you invest.

Make sure to do your own research on what investments are right for you before investing or consider seeking expert financial advice. Please note that this article is meant for information and does not constitute any financial advice.