The tech sector is well-known for containing many incredibly high-value companies, albeit with a relatively high degree of share price volatility compared to more traditional sectors. But why do such companies stand out to such a significant degree?

As at the time of writing, the world’s five largest companies by market capitalisation are tech companies (Apple, Microsoft, Nvidia, Alphabet/Google and Amazon – with Meta/Facebook in at number seven for good measure). The top seven companies (Saudi Aramco makes up the numbers here) are the only seven companies in the world with a market cap of over $1 trillion (1).

Clearly, much of this pattern results from our increasingly digitised world, with its ever-increasing reliance on smartphones, software, social media and so on. For the companies noted above, the array of opportunities that the technological age has provided has allowed them to dominate their particular markets, further driving up their value.

But does the size of those very large companies mean that businesses within the wider tech sector should be able to command high values?

Value relative to earnings

One thing that is clear when you begin to delve into the drivers behind these large tech company valuations is that investors are not in it primarily for dividends. Of the six big tech companies listed, none has a current dividend yield (i.e. dividends as a percentage of share price) of above 0.5% - a return easily outperformed by savings interest being offered by high street banks.

This relationship between value and current earnings can also be observed for tech companies more widely. A sectoral analysis of price-to-earnings ratios (or “PE ratios”, i.e. share price divided by profit-per-share – a measure which ignores dividend policy) across US listed stocks in January 2024 (2) has identified ten sectors which have both a current and forward-looking PE ratio above 40x. Of these ten sectors, six (biotech, healthcare IT, semiconductors, entertainment software, systems & application software and telecoms) are in the tech space.

Riding the Rollercoaster

So it’s pretty clear that it is not this year’s earnings, or even next year’s earning expectations, that is fuelling the high valuations in the tech space.

In the short-term, the prospect of capital growth is a clear draw. Whilst many will clearly remember the tech boom in the 2000s, share performance in the sector has tended to outperform the market in the longer term, with some incredible growth stories appearing as well.

Nvidia, with its dominant position in the market for the infrastructure that supports AI, has a $2.9 trillion market capitalisation in September 2024: a little under two years previously (October 2022), it had been worth less than one-tenth of that, at $280bn.

For listed company valuations, such ‘success stories’ arguably create a ‘virtuous circle’: the prospect of making your money back ten times over in only two years will attract much more speculative trading, further removing valuations from the underlying operational fundamentals.

In the longer term though, despite the extreme valuation metrics in the tech space, high valuations would ultimately need to be underpinned by a belief that there is significant earnings potential that would eventually arise. Interest in Nvidia, for example, has been largely driven by the opportunities that are perceived to arise from developments in artificial intelligence (AI) which many believe will have massive implications on daily life in the future.

These trends show us why it’s important to stay informed. The high valuations in tech reflect the sector’s potential but also remind us that expectations, not earnings, often drive market behaviour. Understanding this is key to making smart choices in this fast-changing sector.

1 - Companies ranked by Market Cap - CompaniesMarketCap.com, 20 September 2024

2 – Aswath Damodaran Useful Data Sets (nyu.edu) - January 2024