The S&P 500 Isn’t That Expensive. Look at Profit Margins.

The index trades at just over 22 times analysts’ expected earnings, in aggregate. That may seem expensive. (TIMOTHY A. CLARY / AFP / Getty Images)

One area of market chatter that’s been growing louder recently is that stocks are too expensive. That’s not necessarily true.

The S&P 500 is up 7% this year, hitting several new records. It now trades at just over 22 times analysts’ expected earnings, in aggregate, for the coming 12 months.

That multiple might look, at a glance, too expensive. It’s at the high end of its range since early 2022—when the Federal Reserve began lifting interest rates, which makes fixed-income returns look relatively more attractive.

A 22 times earnings multiple means that, for every dollar of earnings S&P 500 investors expect to receive, they pay $22 to own the index, yielding them 4.5%, barely above the 4.4% guaranteed yield on the 10-year Treasury bond. So stocks look relatively expensive, given that their earnings this year offer almost no additional return versus safe bonds.

That’s why some investors have grumbled that stocks are too pricey. They have a point; now may not be the best price point to buy more shares. The reality is that the multiple has not gone above where it is now for a long time, and stocks do experience periodic pullbacks in the middle of longer-term bull runs. A pullback could easily happen soon, with multiples where they are, given the number of lingering risks, including more inflation from recently announced tariffs and, relatedly, fewer Fed rate cuts than the market expects. Both would pressure the economy and earnings.

But the other reality is that the 22 times expected earnings multiple looks reasonable, considering where companies’ profitability stands. As companies’ gross margins rise, so do their valuations. Trivariate Research’s Adam Parker’s data show U.S. companies with the higher gross margins average the highest multiples. The lower the margin, the lower the multiple.

Also, the S&P 500’s aggregate multiple is highly correlated to its aggregate gross margin. Parker’s data show that since 1999, as margins rise and fall, so does the index’s price/earnings ratio. Right now, with the aggregate gross margin approaching 50% this year, the multiple of estimated 2026 earnings should be a touch over 20 times. It’s at 20.9 times, so it’s close to where it should be, given where margins are.

“Given how correlated valuation and margins are, we maintain that the market will trade between 20 and 25 times forward earnings,” Parker writes.

The correlation isn’t a coincidence. Higher margins mean more money can flow to the bottom line, giving companies flexibility to invest more in their operations, grow market share, and sustain profit growth. Remember, earnings will grow, so stock returns can still beat bond yields by a lot. More money the bottom line also gives companies flexibility to increase stock buybacks, which boosts earnings-per-share growth—keeping valuations elevated.

The reason the S&P 500’s gross margin has risen—from a tick below 45% before the pandemic—is because of Big Tech. Nvidia’s margin has jumped about 10 percentage points because the majority of its sales now come from extremely high-priced and high-margin artificial-intelligence chips. A similar story is true for Broadcom.

Alphabet and Microsoft have seen smaller gains in gross margins, and Meta Platforms has seen its dip. Apple’s gross margin has risen, as the higher-margin services business has become a larger percentage of its total business. Amazon.com and Netflix have also seen rising margins.

This boosts the index’s aggregate margin because Big Tech comprises a major portion of the index’s gross profit. Non-tech gross margins haven’t been as stellar. The past five years of gains in the consumer price index, which is more representative of companies’ selling prices, haven’t outpaced those in the producer price index, which reflects companies’ costs. So Big Tech has lifted gross margins.

That may be an old story, but it’s important for investors to remember. Big Tech is continuing to grow earnings briskly. In fact, analysts expect the index’s earnings to grow 12% annually from the start of this year through 2027, according to FactSet, above a 9% long-term average. That’s why many strategists’ estimates of the index’s fair value equates to close to its current valuation.

So maybe the market is priced correctly.

Write to Jacob Sonenshine at jacob.sonenshine@barrons.com