This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
Since 2023 began, Wall Street's major stock indexes have been practically unstoppable. The ageless Dow Jones Industrial Average (DJX: .DJI), benchmark S&P 500 (SP: .INX), and growth-powered Nasdaq Composite (NASDAQ: .IXIC) have ascended to numerous record-closing highs.
Investors haven't hurt for catalysts, with a laundry list of positives responsible for perpetuating this more than two-year rally. This includes the rise of artificial intelligence (AI), Donald Trump's election night victory (all three stock indexes soared during his first term in the White House), and better-than-expected corporate earnings, to name a few key variables.
But with the stock market sporting one of its priciest valuations in 154 years, corporate execution needs to be flawless to maintain this rally. Unfortunately, some of Wall Street's most influential companies have an earnings quality problem — and it simply can't be ignored any longer.
A painful realisation: The stock market is historically pricey
When investors are attempting to value a stock, they'll often turn to the traditional price-to-earnings (P/E) ratio. This measure divides a company's share price into its trailing-12-month (TTM) earnings per share (EPS). It's a fantastic tool for quickly determining the cheapness or priciness of mature businesses, relative to its industry and/or the broader market, but it can get tripped by growth stocks and shock events that reduce EPS.
A considerably better measure of value for the broader market is the S&P 500's Shiller P/E Ratio, which is also commonly known as the cyclically adjusted P/E Ratio (CAPE Ratio). Instead of using TTM EPS, the Shiller P/E Ratio is based on average inflation-adjusted EPS spanning the last 10 years. This smooths out the effects of shock events and allows for true apples-to-apples valuation comparisons.
Even though the Shiller P/E Ratio wasn't created until the latter half of the 1990s, it's been back-tested to January 1871, allowing for 154 years of historic valuation comparisons.
S&P 500 Shiller CAPE Ratio data by YCharts.
As of the closing bell on Feb. 6, the S&P 500's Shiller P/E clocked in at a reading of 38.37, which is just shy of its closing high of 38.89 for the current bull market. More importantly, it represents only the third time in 154 years where this valuation tool has topped a reading of 38 during a continuous bull market.
Widening the lens a bit further, there have only been a half-dozen occasions since January 1871 when the Shiller P/E has surpassed 30, including the present. Following the previous five instances, the S&P 500, Dow Jones, and/or Nasdaq Composite shed 20% to 89% of their value.
A historically pricey stock market has been a harbinger of trouble to come for Wall Street for more than 150 years, which is why earnings quality from America's most influential businesses is more important than ever. The problem is that a dollar in corporate profit isn't always what it's cracked up to be.
Some of Wall Street's most influential companies have an earnings quality problem
Businesses that offer cutting-edge innovations and/or possess seemingly insurmountable moats and competitive advantages have led the broader market higher. However, not all of these businesses are as amazing as they appear on the surface.
An ideal example of what I'm talking about is electric vehicle (EV) maker Tesla (NASDAQ: TSLA), which recently reported $8.99 billion in pre-tax income in 2024. Superficially, Tesla appears to be firing on all cylinders, with its energy generation and storage segment growing by double digits and the company registering its fifth consecutive year of generally accepted accounting principles (GAAP) profit. Most EV makers aren't even profitable.
But if investors really dig into Tesla's operating results, they'll find that $2.76 billion of its pre-tax income came from selling regulatory tax credits to other automakers, and another roughly $1.57 billion traces back to interest income generated from its cash. The company also recorded a $600 million mark-to-market gain on the value of its Bitcoin holdings during the fourth quarter. While I'm not faulting Tesla for taking advantage of these opportunities, it's worth pointing out that more than half of its pre-tax income originates from unsustainable, non-innovative sources.
Though the buzz surrounding Tesla ties into full self-driving, the incorporation of AI, robotaxis, and autonomous robots, the reality is that most of Tesla's income comes from regulatory credits given to the company for free by federal governments, interest income on its cash, and digital asset adjustments.
But this isn't just a Tesla problem. Poor earnings quality is a widespread issue among a number of prominent stocks.
Last week, AI-driven data-mining specialist Palantir Technologies (NASDAQ: PLTR) knocked Wall Street's socks off by reporting a re-acceleration of its growth rate. The company's Gotham platform, which aids federal governments with data collection and mission planning/execution, has helped propel the company's GAAP profits higher.
But amid Palantir's double-digit sales growth and 2025 revenue guidance that handily topped Wall Street's consensus is the reality that a significant portion of its pre-tax income derives from interest income earned on its cash. Palantir reported $489.2 million in pre-tax income in 2024, $196.8 million of which was interest income. Investors don't expect a company trading at 88 times TTM sales to be generating 40% of its annual pre-tax income from an unsustainable and non-innovative source like interest income.
Tech goliath Apple (NASDAQ: AAPL) serves as yet another example. The company behind the undisputed leading smartphone (iPhone) in the U.S. is expected to enjoy tailwinds from the incorporation of Apple Intelligence into its physical devices. Apple's AI model has the potential to reignite consumer interest in iPhone, Mac, and iPad.
Something else Apple is known for is its world-leading share repurchase program. Since the start of 2013, it's repurchased almost $750 billion worth of its common stock and lowered its outstanding share count by 43% in the process. Buybacks of this magnitude help to lift EPS and can make a company's stock appear more attractive to fundamentally focused investors.
But in Apple's case, buybacks have masked the stalling of its physical product growth engine and a notable decline in net income. Even though its full-year EPS has been fairly static thanks to its ongoing share repurchase program, net income has declined from $99.8 billion in fiscal 2022 (ended Sept. 24, 2022) to $97 billion in fiscal 2023 (ended Sept. 30, 2023) to $93.7 billion in fiscal 2024 (ended Sept. 28, 2024).
With the stock market historically pricey, corporate earnings can't be taken at face value. Regardless of how important or influential a company might be to fuelling Wall Street's rally, investors need to ensure businesses are producing quality profits and not those masked by unsustainable and non-innovative sources.
This article was originally published on Fool.com. All figures quoted in US dollars unless otherwise stated.
