AI on the stock market – how do you measure financial hype?

Microsoft, Nvidia, Amazon & Co. have suffered losses. Is a financial crisis breaking out? Here are two simple metrics to help you better assess stocks.

Railways, cars, the Internet – and currently AI: Whenever an industry dominates the stock market, caution is advised in the long term, says nau.ch financial expert Stephan Lehmann-Maldonado. – Pixabay

The most important things in brief

AI companies dominate the stock markets like dotcom companies once did.
The price-earnings ratios of many stocks seem astronomically high.
So far, every hype has dissipated sooner or later.

What happened? At the beginning of August, stock prices around the world began to plummet. Macroeconomic reasons can be cited to explain this. But we will limit ourselves to observations.

Since the beginning of 2023, the financial markets have been dominated by artificial intelligence, or AI for short. The “magnificent seven” – Microsoft, Nvidia, Apple, Alphabet, Amazon, Meta and Tesla – make up around 30 percent of the American stock market barometer S&P 500. Yet these companies do not produce anything that is essential for people’s survival.

AI like railways?

Such dominance of an industry occurs when a hype breaks out about new technologies. At the end of the 1990s, Internet companies dominated the indices, in the 1960s it was the oil and car companies – and 140 years ago, when the first stock index, the Dow Jones Average, was launched, it was the railway companies.

The internet, cars and trains have become an integral part of our everyday lives. But hardly anyone remembers the stock market stars of yesteryear. “This time everything will be different,” is often said. Really?

Calculate like the financial professionals

Let’s focus on two simple financial ratios that reveal quite a lot about a stock: the price-earnings ratio (P/E) and the price-earnings-to-growth ratio (PEG). The P/E ratio is calculated simply: the share price divided by the earnings per share. The quotient shows how many times the company’s profit is included in the price.

Nvidia chips play a key role in software with artificial intelligence. The AI boom is also making Microsoft shares popular. – Andre M. Chang/ZUMA Press Wire/dpa

If Microsoft has a P/E ratio of over 35, stock market traders are prepared to pay 35 times the annual profit to buy a share. A bit much, isn’t it? For chip developer Nvidia, the P/E ratio is even 91. Theoretically, you would have to wait 91 years for the investment in the share to pay off.

Fine art: estimating profits!

As a rule, a high P/E ratio is justified by the fact that strong profit growth is to be expected. To take this into account, the PEG ratio is used. Dividing the P/E ratio by the growth rate of profits gives the PEG. The crux of the matter: the growth rate of profits has to be estimated – in other words, you have to keep your thumb in the wind.

Let’s assume that an AI company has a P/E ratio of 50. If its profits increase by 50 percent, the PEG is 1. As a rule of thumb, values below 1 are attractive, values above indicate exaggeration. For Microsoft, the PEG is around 2.9, for Nvidia around 0.46. But if the profit prospects deteriorate, the most beautiful figures become worthless.

Like the dotcom bubble?

Perhaps the past is the best indicator of the future. Before the dot-com bubble burst around the millennium, even venerable professors raved about a “new economy” with new rules. But history teaches us otherwise: most markets with astronomically high P/E ratios collapse sooner or later.

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About the author:

Stephan Lehmann-Maldonado has been collecting coins since he was a child and specialized in banking and finance during his economics studies at the University of Zurich. At the same time, he wrote for business media, taught as a business teacher and deepened his knowledge in banking practice. Today he runs an agency for clear communication – and is happy if the financial sector can also get on board with it.

Stephan Lehmann-Maldonado writes regularly on Nau.ch about finance. – zVg