Thursday, December 8, 2011

Why Do Large Cap Firm's Trade at a Discount to Market?

Aleph Blog outlines why he believes "behemoth" companies (i.e. firms with a market value greater than $100 billion) trade at relatively compressed price to earnings ratios:

For Behemoth companies to achieve large earnings growth, they have to find monster-sized innovations to do so. Those don’t come along too regularly. Even for a company as creative as Apple (or Google), it becomes progressively more difficult to create products that will raise earnings by a high percentage quarter after quarter.

As a result it should not be a surprise that Behemoth stocks trade at discounts to the market when global growth prospects are poor. They have more assets and free cash flow to put to work than is useful in a bad environment. Not every environment offers large opportunities.
The below chart outlines, by sector, the market cap of the current 39 behemoths using data from a follow up post at Aleph Blog (he adds even more granularity in his post).

I would also add that I believe these behemoths trade at an aggregate discount due in part by their composition. Financials (and to a lesser extent energy firms) trade at a large discount due to the damage they inflicted upon themselves and the threat of future regulatory restrictions that may impede profitability, both of which may force them to dilute shareholders as they raise / write-down capital. Technology firms on the other hand are constantly threatened by innovation and becoming irrelevant by the next generation of firms (i.e. what happened to Yahoo via Google), thus earnings become difficult to project past even a few years.