The Stock Market is 'Priced to Insanity'.

The Magnificent 7 is seeing nice gains following Q4 earnings, with the group now up about 9% for the year. My next guest says while the names are richly priced, only one is quote priced to the point of insanity. Let's bring in the Dean of Valuation, Aswath Damodaran, NYU Stern School of Business Professor. Welcome back!

If you don't know Aswath Damodaran, he is a legend of the online finance community. As the anchor says in that clip, he is known as the Dean of Valuation because he teaches corporate finance and equity valuation at the School of Business at New York University. But he's actually known as the Dean of Valuation across the internet. The reason he is such an online legend is that he openly posts all of his lectures on his YouTube channel for free. He has approximately 1,100 lectures on his channel, not a single paywall. Chances are you've probably seen some of these videos recommended to you before.

So, long story short, Aswath is a god when it comes to valuing stocks, which is why this CNBC interview is super interesting. With Damodaran saying he thinks the Magnificent 7 – Apple, Amazon, Meta, Tesla, Nvidia, Google, and Microsoft – are egregiously overvalued, with one of the seven stocks, no prizes for guessing, quote priced to insanity.

Take a listen to this: "The one that's priced to insanity, you suggest, is NVIDIA, which is interesting because you own it along with all of the others, correct? Yeah, you bought these stocks at the right time. They were amazing buys at some point in time. At today's prices, I mean, all of the stocks look overpriced, but I think Nvidia stands out as particularly overpriced."

At first, I was a little surprised by Aswath's views, but then, looking a little bit deeper into the numbers, it turns out that these views from the Dean of Valuation are really not surprising at all. I went and had a look at the current valuations of the Magnificent 7, and here's the chart for their P/E values. Remember, the long-term market average P/E is around 16. Yahoo charts has it at 23 as of the end of Q3 last year.

Remembering we haven't seen all the S&P 500 companies report Q4 earnings as at the time I'm recording this, but look at the Magnificent 7, responsible for 60% of the S&P 500's gain last year. The only companies we see with a P/E in the 20s are Google and Apple. Meta sits in there at 30, but then things start to really take off: Microsoft at 38, Tesla 44, Amazon 60, and leading the pack we have the market darling Nvidia at a P/E of 95.

So, it's not surprising that Damodaran points out Nvidia as being priced to insanity. I mean, just to get a collective sense of what 7 companies account for in the S&P 500, these seven stocks alone account for 70% of the overall market cap of the index. They account for 11% of revenues, but they do account for 27% of gross profit. So they're very profitable, very valuable companies.

And you can get pretty close to the current prices for the other companies, and very, I can't even get close. But I wanted to go a little bit deeper than your standard P/E ratio to look into this a bit further. P/E ratios are a good quick measure to see the general ballpark of how cheap or expensive a stock is, and you hear the term thrown around all the time on CNBC.

But really, what actual stock investors look at to value companies properly is what's called the discounted cash flow analysis. For those that don't know, it's a model that estimates the future growth in cash flows of a business, then discounts the future cash flows to what they're worth today to calculate what the intrinsic value of the business might be to an investor right now.

This is a very, very important skill to have as an investor, and I will quickly mention we do teach the discounted cash flow model in Introduction to Stock Analysis over on New Money Education. The link is in the description if you wanted to check it out.

What I did for this example is I imagined for each of the Magnificent Seven companies, as of today, they'll be able to grow their earnings at 12% per year for literally the next 10 years. For the discount rate, I used 15%, because, as I always say, if we're asking for any less than that per year, what's the point? May as well buy an index fund.

Then, for the terminal value, I multiplied the 10th year free cash flow by the average year-end price-to-free cash flow multiple of each business over the last 10 years.

Now, to my surprise, two of the businesses turned out to actually be slightly undervalued, with no margin of safety, that is. But as you can see, five out of the seven all turned out to be pretty egregiously overvalued. When you zoom into Nvidia, the results get pretty bonkers.

Assuming 12% growth in free cash flow each year for the next 10 years, asking for a 50% annual return gets you an intrinsic value of around $200 billion, whereas the current market capitalization sits around eight times higher than that.

So, I don't want to annoy the Nvidia shareholders out there, but the company does seem very overvalued right now. But what does this mean? It means that Nvidia investors generally are buying in, accepting a much lower annual rate of return than 15%, or what's more accurate in this instance, they're expecting the company to grow a lot faster than 12% per year.

But how bad is it? Well, in my simple model, to get the intrinsic value to match the market cap, investors would need to see just over 40% growth annually from the business over the next 10 years. So that's really the question at hand: Could Nvidia grow into its monster valuation over time?

That's what the anchor is talking about in this next clip: "I'm surprised somewhat, if only because the valuation of Nvidia has come down as its earnings and guidance have gone up. So, in some respects, what was perhaps insane has actually been justified. In some respects, no, in a sense there is an adjustment process going on. I know where it'll end up. The truth is, when this process started, people assumed that Nvidia's domination of AI, the chip part of the business, would continue in perpetuity. I think the other chip companies are waking up. Things are going to start to scale down. So, I think in spite of the come down in price, I am more wary about Nvidia than I was, simply because it's – I mean, last time I valued Nvidia was at $400. Gives me some kind of perspective in terms of at $682. I mean, that's a stretch. That's given their current earnings potential in cash flows. I just can't get that. Maybe I'm just missing some part of the picture, but to me it doesn't make sense."

So, what Damodaran is saying here is he personally can't see Nvidia hold onto a monstrously high growth rate for a long enough period of time to create a scenario where investors who are buying the stock now see a positive ROI.

As you can see in Nvidia's numbers, they are in full explosive growth mode. They grew their revenue by 34% in a single quarter alone. Their profitability, or their net income, is up 50% quarter-over-quarter and up 1,259% year-over-year. They are fantastic growth numbers. But Damodaran's point is that no company can do this stuff in perpetuity.

Even Tesla, who have guided for and more or less achieved 50% growth in vehicle deliveries per year, have stated that they just can't keep that up now. So, as Damodaran says, when this whole bull run started for Nvidia, people were assuming this explosive growth in chip sales would more or less continue in perpetuity. But Aswath cautions that this happens very rarely, and thus he's much more cautious on the stock now.

I mean, you're not alone; that's for certain. Look, today on my earlier program, the halftime report, Josh Brown, who's been in Nvidia longer than anybody I know, sold 20% of it. I want to listen to what he said and let's react on the other side: "It just feels like there are people who are so bullish, they've run out of superlatives and ways to describe Nvidia's market position and their technology dominance, and they're just like raising price targets. It's almost on a weekly basis. It's become breathless. I just felt like the chart went vertical, and people have just like lost their minds. I'm as excited about generative AI as anyone else, and I'm bullish. I'm just not that bullish where I think a stock should go up 20% every month just because the alarm clock went off and the sun came up."

What are your thoughts?

No, I agree with them. I think AI has become this buzzword that people use to justify pretty much anything they want. I mean, I think collectively, AI is going to be a net negative for markets. It's going to be a great positive for companies like Nvidia, but I think the laziness with which people attach premiums to companies just because they see the word AI – and you see that partially with Microsoft as well – is, I think, terrifying. Because at some point in time, reality is going to play out, and it's not going to match those expectations.

And wouldn't it be great if we had some sort of example for exactly what Damodaran was just talking about? Some historical scenario where there was so much hype around a particular technology that companies were doing anything they could to associate themselves with this trend. A scenario where there's so much speculation that any stock even remotely related to the technology in question would just skyrocket based on absolutely no business fundamentals.

Oh, that's right! Damodaran in that clip is basically comparing the stock market right now to the tech bubble. Although back then, it wasn't AI that caused all the speculation and overvaluation; it was the internet. Every company you looked at was trying to convince investors that it was on the cutting edge of internet technology. Some would even change their names to include ".com" just to lure in investors. In fact, adding "dot-com" to your business name, on average, increased your stock price by 74% back then.

But ultimately, what happened to this technology-centered stock market bubble? Top to bottom, the S&P created more than 50%, while the NASDAQ fell 75%. As Damodaran says, the laziness with which investors attach a premium to those companies that mention the word AI is worrying, and in his opinion, there will be a time where reality will play out, and expectations won't be met.

But what about companies that are already genuinely establishing themselves in the field of AI, such as Microsoft, who have a very strong partnership with OpenAI and are already incorporating the benefits of AI into their marketable products? Is there a case for a company like Microsoft?

I'm wondering when you look at these other companies within the so-called Magnificent 7, like Microsoft, for example, is it legitimate that its multiple now, as in the low 30s, is how profound this relationship with OpenAI can really be?

"I think it's a company that's closest to creating a subscription model around AI in which it can make money. I can't think of another company that's as close. So part of that increase, again, comes from the reality that AI is going to open up new businesses. But as a long-term owner of Microsoft, again, I'm looking at $44 of $400 per share and I'm saying, you know, I mean, I'm definitely happy that it's gone up to $400, but again, a lot has to go right for this price to be the right price. Pricing in that expectation sets you up for unpleasant surprises down the road."

So, not even a company like Microsoft, who can even now earn real dollars from their efforts in AI, does Damodaran still can't make a case for that current valuation.

But what's really interesting is that Damodaran is not the type of guy to simply throw the baby out with the bathwater when it comes to the Magnificent 7. While he does see broad overvaluation and egregious overvaluation in some of the seven companies, he can still look at each business on its merits.

Believe it or not, he does still find two of the best businesses to be an attractive investment proposition for him. Have a listen to the Dean talking about these two stocks: "I think there are two companies in the seven that if you really, really wanted to buy these stocks and you've never owned them, you have missed out. One would be Tesla, which will surprise you because I bought Tesla just a couple of weeks ago at about $180. The other would be Apple, which I think is adjusted down. It's still a cash machine, but Apple over the last 15 years has lived from iPhone upgrade to iPhone upgrade. It has a bad year, then a good year based on whether there's a big upgrade during the course of the year.

So, I think Apple will bounce back a little bit. It's a slow growth cash machine, and people have to be realistic about what they're getting. But I think that at $188, it's as good a buy as any of the other seven. So, Apple and Tesla would be my two buys among the seven if you really wanted to add two of these stocks to your portfolio."

I don't take it that he was particularly endorsing either of the businesses when compared to the plethora of other companies out there. But it's interesting to hear him say that he doesn't find Tesla or Apple to be quite as ridiculously overvalued as the other stocks.

Tesla's an interesting one; a lot of arguments both ways on the business, and it's one of those stocks where the valuation really comes down to what you believe the execution looks like on the new technologies, like the full self-driving, the Tesla Cybertruck, and the next-generation vehicle platform.

However, I do tend to agree with him more on the Apple front, where investors kind of know what they're getting with Apple. It's a slow-moving cash cow at this point. A lot of people are getting excited about the Vision Pro, and I understand it. But at the same time, it's really not moving the needle for Apple until millions of people are buying it, which realistically isn't happening anytime soon.

So, I can see the argument from Damodaran on Apple, and when it comes to Tesla, I think that one is definitely down to each individual, so I'm going to sit on the fence there. I'll let the comments figure that one out.

But with that said, guys, that is what the Dean of Valuation has to say on the Magnificent 7. One thing, if you do want to learn how to analyze and value companies like Damodaran, he has plenty of free tutorials on his channel.

Or, if you'd be interested in learning the full start-to-finish process from me, including three valuation methods, which does include the discounted cash flow analysis, please check out Introduction to Stock Analysis down in the description. All proceeds go towards supporting this channel and, of course, my team.

So, a heartfelt thank you for each and every one of you that do decide to support the channel and sign up. But with that said, remember to like the video, subscribe, and I'll see you guys in the next one.