Stretched Valuations

This is tmrw — a weekly note on money, decisions, and what tends to matter over time.

Powered by Fjell Capital.

Over the last few weeks, we have taken a deep dive into AI.

Last week, we had a pretty plain vanilla and practical edition on the value of simplicity. This week, we are diving into your portfolio, the markets, and the valuation of your assets.

No matter what your balance sheet looks like, or what the composition of your net worth is, it is filled with stocks, bonds, cash, real estate, private businesses, maybe alternatives, either in the form of individual securities themselves or through a fund structure. Every single investment you own, likely thousands of them, has a valuation assigned to it. And those valuations represent a belief about the durability of the cash flows sitting beneath the investment.

Valuation is what the market is willing to pay today based on what it believes that asset can produce tomorrow. Historically speaking, current valuations have had strong predictive value for future returns. If valuations are low, future returns will likely be higher, and vice versa.

I wrote about valuations last summer in a piece called When Everything Yields the Same. What was interesting then was that cash, stocks, and bonds were all yielding about the same. Roughly 4.5% or so. That was a strange moment because it forced a very simple question. What am I actually being paid to own here?

What has changed since last summer is that equities are higher, interest rates are lower, and fixed income is broadly in the same trading range. Meaning, stocks are more expensive broadly, holding cash yields less, and fixed income is roughly the same.

And what really caught my attention here was this past weekend.

I was driving my son home from hockey and he happened to fall asleep, so I turned on a video from Patrick Boyle to listen to while driving. It was on the beyond eye-watering valuation of SpaceX’s expected June IPO. As of now, this is not set in stone. But the number being talked about was around $1.75 trillion. If you put that against expected revenue, you get to something like 94 times revenue.

Not 94 times EBITDA. Not 94 times earnings. Ninety-four times revenue.

To give you some context, let’s assume there was a small laundromat in your community for sale. It generates about $250,000 in revenue a year and makes $50,000 for the owner. Your friend pulls you aside over dinner, as this laundromat has become the talking point of the business owner community. Why? Because it is for sale for $23.5 million.

That is right. For $23.5 million, you can buy a $50,000 income stream.

Okay, that is the valuation.

Obviously, SpaceX is a once-in-a-lifetime company that is doing things that could change life on earth as we know it. The company is the opposite of a local laundromat in every way. I am not here to bet against Elon Musk either. SpaceX may end up being worth every bit of that valuation over the coming years and decades, but that is not the point.

The point is that valuations matter because, at some point, the math must work out. You would never spend $23.5 million for a $50,000 yearly income stream.

When the market is paying up for the future, there is just less room for error.

Since the pandemic, the world has been awash in liquidity. I wrote about this in our annual letter as I recapped what happened in markets last year and the themes that defined the environment. Too much liquidity has a way of distorting financial reality. It can make prices feel normal that probably would not have felt normal ten years ago. It can make hype feel like fact. It can make people stop asking the question as they stare at ChatGPT and think anything is possible.

But valuations still matter. They are the counterbalance to hype. A fireplace for the fire to burn in.

And we live in a world that is defined by hype.

I am not a movie guy and I do not exactly know what Marty Supreme was about. What I do know is that it was hyped globally. That same dynamic has bled into markets in a much bigger way since the pandemic. We are in a once-in-a-lifetime buildout of technology that is supposedly going to change the world (something I explored in The Age of Everything & Excess). The 2010s at this point look boring. The 2020s are about blockchain, AI, rockets and robots, and the endless race to define and build the world we are all going to live in in the 2030s.

Interesting times indeed.

But back to valuations.

There is a Buffett idea that I always keep in my memory bank as we invest at Fjell. You can buy a great company at a bad price and lose money. You can buy a bad company at a great price and make a great investment. Price matters. And the valuations inside your portfolio matter right now.

Because the earnings yield on the S&P 500 is lower than it was a year ago. In plain English, investors are paying more for the same stream of earnings than they were nine months ago. There is a known understanding in markets right now that AI will increase margins, which helps explain higher valuations today.

That is probably true over the long term, but again, at some point, the math needs to work out for you and your family.

As multiples expand, risk increases because the payback period extends.

But this is where I think the conversation gets important.

You probably do not think of yourself as an investor per se. You are a dad, or a mom, a leader in your company, a son, a golfer, a runner, or whatever you’d describe yourself as. You are working to protect what you have built, create flexibility, retire well, and think about legacy. The portfolio is not the point. The portfolio is there to support the life.

That is why valuations matter.

The real question is not whether the market is expensive in some abstract academic sense. The real question is whether the assets inside your portfolio still make sense for the job your wealth needs to do.

• Do you know what is inside your portfolio?

• Do you know why it is there?

• Do you know what kind of future those valuations are assuming from here?

Those are important questions. That is what I am thinking about for our clients in all of this.

Because a portfolio is not just a statement that shows up every quarter. It is a collection of decisions. It is what you are choosing to compound in.

Valuations do not tell you everything. But they do tell you quite a bit. They tell you how much optimism is already in the price. They tell you how much good news the market may already be assuming. And they remind you that even great assets can become fragile when too much has to go right.

That is why valuations must be known and understood.

When the world gets louder, and it is and will continue to do so, it pays to know this stuff.

If you’d like to talk through how this applies to your own financial life, you can learn more about our work at Fjell Capital here.

And if you found this edition useful, let me in the poll below or reply with a quick note—I read every response.

More next week.