Is investing by cap size still appropriate? In a Nov. 15 commentary, H. Bradlee Perry wrote a rather intriguing piece regarding the Standard & Poor's 500. In it, he pointed out the degree to which very high price-earnings ratios are now focused within the largest 25 market caps, and he went on to make some interesting observations questioning the relevance of the "average p/e" within the S&P 500.
For me, his views raised some more fundamental questions about the continued use of market capitalization as a measure of company size.
Cap size, after all, is simply the product of the price of a stock times the number of shares outstanding. Once upon a time, when p/es fell within a much narrower band, this equated fairly well with company size.
The market's valuation of a company was based on a mixture of factors -- including earnings, revenue and forecasted growth --that tolerably well approximated "company size." Now, however, when some companies sustain p/es in excess of 200 and others languish with p/es of 15, capitalization is as much a measure of Wall Street's subjective judgment of the company as it is a measure of the size (and, by extension, the stability) of a company.
Yet, it is still almost universally used as a proxy for "company size."
To cite a single example, let's consider Yahoo! Inc. With a recent p/e in the range of 440 and a capitalization of $60 billion, it is well within the range of "large-cap" by just about any standard. Yet if it were trading at a still-healthy p/e of, say, 44 instead of 440, its market cap of $6 billion suddenly would cause it to be considered "midcap" -- without any material change to the size of the company. (Since being added to the S&P 500 in mid-December, Yahoo's stock price and its p/e multiple have skyrocketed even higher.)
Surely, Yahoo's 700 employees and moderate revenue do not warrant its being considered a large corporation. And someday the p/e may yet come down, and the company will then be considered midsized, even as it continues to grow.
Yahoo's extremely volatile price history is not reflective of a large corporation, and this is true in general of corporations we are now in the habit of classifying as "large" because of market valuations rather than more objective measures.
So if the intent of categorizing companies by size is to put them into groups that are expected to behave in some way similarly, we have gone seriously astray when we place Amazon.com Inc. or eBay Inc. or Yahoo! in the same group with General Motors Corp. and Merck & Co.
Now let us go back to Mr. Perry's observation that the largest market-cap stocks in the S&P 500 also are the companies with the highest p/es.
It suddenly is apparent why this is so. The p/e multiple is, after all, the price of a stock divided by its earnings per share, and market cap is the price times the number of shares. A very high price will of course produce both a high p/e and a high market cap!
It is time to reconsider the mathematics here. Is it really valid even to speak, in today's frothy market, of p/e ratios by market cap range? I don't believe it is. Both, after all, contain price as a key component.
In a sense, it is like saying "show me the companies most highly valued by Wall Street (high p/es), grouped within breakpoints that denote how the companies are valued by Wall Street (market cap).
Consider the following implication: A manager evaluates his portfolio and is concerned by its relatively high weighted-average p/e. But, because the portfolio's stocks are mostly large-cap, i.e., large, stable corporations, he concludes his risk is not that significant.
Yet many of his stocks are probably large-cap precisely because they have high p/es.
I would propose that company size be evaluated by a more objective measure such as gross revenue instead of capitalization.
It is true that this number tells us nothing of profitability or forecasted growth. But that is precisely the point. These numbers are incorporated into other characteristics. And when speaking of "company size," we need to be isolating only the information that bears explicitly on company size, excluding all the "noise" of how Wall Street is valuing the company, as valuation is already a major component of other measures that will be used in relation to company size.
Daniel A. Blum is project manager-software development at Russell/Mellon Analytical Services, Everett, Mass. The ideas expressed in his commentary do not represent an official view of Russell/Mellon or its parent companies, Frank Russell Corp. and Mellon Bank.