S&P 500 Bottom - Up Valuation and Market Outlook for Q2 2025
Summary
It’s not a Stock Market, but a Market of Stocks
Every quarter we like to assess the fundamental state of the market by closely analyzing the most important companies. To understand if the S&P 500 has more upside than downside, we need to define the recent rally leaders, create DCF models for each, and set price targets.
The distance from the last closing price to the 1-year Price Target will inform us of the risk-reward currently offered by the market. We shall rely on our Machine Learning models and company guidance to generate these models. The aim of this research piece is not necessarily to create accurate models individually, but as a group.
Year Ahead Outlook
The last time we have compiled this analysis, average valuations for S&P 500 companies had become fairly stretched. Today, we find similar valuation levels, hovering around a P/E ratio of about 25, using earnings realized in the past 4 quarters. On a 12-month forward basis, the P/E ratio for the S&P 500 is 20.5. This P/E ratio is above the 5-year average (19.2) and above the 10-year average (17.8).
Equities are currently in the 89’th percentile range in terms of valuations for the current cycle, having been more expensive only during the post-covid rally. This series could revert to the mean in one of two ways:
Prices fall, thereby reducing the P
Earnings grow, increasing the E as a result
In any case, there is a limited potential for valuation expansion, as the chart below clearly illustrates:
In the day-to-day gyrations of the market, valuations rarely matter - on the contrary, they are a terrible market timing tool. From time to time, they do come up in the narrative. Two recent examples come to mind:
“On balance, the staff continued to characterize the system's financial vulnerabilities as notable but raised the assessment of vulnerabilities in asset valuations to elevated, as valuations across a range of markets appeared high relative to risk-adjusted cash flows.”
- FOMC minutes, May 22, 2024
“I want to make it really clear, OK? We’re not going to buy back a lot of stock at these prices […] Buying back stock of a financial company greatly in excess of two times tangible book is a mistake”
JPM CEO Jamie Dimon, on timing of a potential boost to the bank’s share repurchase program
Since we are discussing a year-ahead outlook in this article, it’s important to understand the broader context of today’s market pricing and what exactly it entails. The S&P 500 Earnings Per Share for FY 2023 was $192. Analysts are currently projecting FY 2024 EPS to come in between $245 and $258, implying an EPS growth rate of 27% - 34%. Here’s the only issue: since 2021, S&P 500 EPS growth has been slightly negative, at -2.7%:
We are now in a situation where earnings need to catch up to valuations. In order to get a higher number on the S&P 500 index one year from now, a ~30% EPS growth not only needs to actually happen, it needs to be exceeded (as it is already priced in). Not only that, but inflation also needs to remain muted. As such, there is a tangible risk of disappointment for investors, even in the absence of a recession. Simply insufficient growth could lead to lower stock prices in 12 months.
Let’s explore which market moving companies offer the most compelling upside…
Defining Market Leadership
In order for us to focus on the correct companies, we need to find out what individual stocks are leading the market higher. Helping us achieve that goal is the concept of BETA (Y-axis), combined with Market-Cap (X-Axis) and Dollar Transaction Volume (filter). A stock’s beta is calculated using both correlation and covariance; the higher the number, the more that stock is moving with the market. Having a significant Market-Cap and Transaction Volume insures that the stock is also a driver for the market due to its size.
We’ve set the screener to account for all relevant factors and the market leadership can be defined as follows:
Microsoft Corp (MSFT) - 7.15%
Apple Inc. (AAPL) - 6.30%
Nvidia Corp (NVDA) - 4.53%
Alphabet Inc. (GOOG) - 1.99%
Amazon.com Inc (AMZN) - 3.71%
Meta Platforms, Inc. Class A (META) - 2.52%
Eli Lilly & Co. (LLY) - 1.43%
Tesla, Inc. (TSLA) - 1.28%
Broadcom Inc. (AVGO) - 1.34%
Jpmorgan Chase & Co. (JPM) - 1.24%
These are the top 10 companies that matter today and are responsible for the bulk of index-level price moves. We have excluded Berkshire Hathaway (BRK-A) from this list, as it is a conglomerate holding company and its structure is more akin to an ETF than a single stock.
In total, these stocks account for 33% of the S&P 500’s weighting. There are also significant companies that could be future contenders for the “top 10” like:
Visa Inc. (V) - 1.06%
Walmart Inc (WMT) -
UnitedHealth Group Incorporated (UNH) -
Exxon Mobil Corp (XOM) -
Mastercard Incorporated (MA) - 0.91%
Procter & Gamble Company (PG) -
Johnson & Johnson (JNJ) - 0.9%
Costco Wholesale Corp (COST) - 0.76%
Oracle Corporation (ORCL) -
Merck & Company Inc (MRK) -
But these stocks only account for 7.85% of the overall index weighting. We shall cover the valuation of this second echelon of top tier companies in a future article. But for now, we’ll focus our machine learning models on the top 10.
Analyst Price Targets and Statistics
We’ll input these stocks into a table containing the latest Analyst Price Targets (no older than 1 month), calculate the potential capital appreciation (equally weighted) as well as weighted according to index constituency.
According to analyst targets, the fundamental capital appreciation potential sits at a combined 10.71%, assuming an equal weight distribution. Adjusted for index weighting, the figure is slightly lower, at 10.44%. However, looking at the distribution of potential capital gains, the bulk of potential capital appreciation is not concentrated in the “magnificent 7” stocks. Instead, Amazon (AMZN) is considered to be the biggest bargain, followed by Broadcom (AVGO) and Microsoft (MSFT).
Let’s explore these price targets in detail and understand the underlying assumptions. We will employ the help of our ML models for this task, and set projections to Neutral. We will also consult various other sources in order to glean a better insight into the specifics of every company. As an extra step before assigning a Price Target, we will check with individual sell-side analysts and see if our models are in agreement.
Models & Price Targets
Microsoft Corp. (MSFT)
Signal Sigma PT: $503 (Raised from $483), 16% CAGR
Analyst PT: $505
Upside: ~21%
Rating: BUY
Assumptions:
11% Revenue Growth
70% Gross Margins
25% OpEx pct Sales
23.4 x EBITDA Multiple
Apple Inc. (AAPL)
Signal Sigma PT: $206 (Raised from $171), 5% CAGR
Analyst PT: $250
Downside: -9.19%
Rating: HOLD
Assumptions:
4.0% Revenue Growth
48% Gross Margins
14.5% OpEx pct Sales
24.7 x EBITDA Multiple
NVIDIA Corporation (NVDA)
Signal Sigma PT: $174 (Raised from $135), 50% CAGR
Analyst PT: $155
Upside: ~38%
Rating: BUY
Assumptions:
20% Revenue Growth
70% Gross Margins
10% OpEx pct Sales
65 x EBITDA Multiple
Alphabet Inc. Class C (GOOG)
Signal Sigma PT: $208 (Raised from $193), 20% CAGR
Analyst PT: $210
Upside: ~23%
Rating: BUY
Assumptions:
10.8% Revenue Growth
60% Gross Margins
26% OpEx pct Sales
17.2 x EBITDA Multiple
Amazon.com Inc (AMZN)
Signal Sigma PT: $207 (Raised from $205), 30% CAGR
Analyst PT: $222
Upside: ~15%
Rating: HOLD
Assumptions:
10% Revenue Growth
20% Gross Margins
8% OpEx pct Sales
25 x EBITDA Multiple
Meta Platforms, Inc. Class A (META)
Signal Sigma PT: $586 (Raised from $514), 14% CAGR
Analyst PT: $516
Upside: ~25%
Rating: BUY
Assumptions:
12.5% Revenue Growth
80% Gross Margins
38% OpEx pct Sales
17 x EBITDA Multiple
Eli Lilly and Company (LLY)
Signal Sigma PT: $913 (Raised from $894), 30% CAGR
Analyst PT: $894
Upside: ~11%
Rating: BUY
Assumptions:
17% Revenue Growth
81% Gross Margins
45% OpEx pct Sales
37 x EBITDA Multiple
Tesla, Inc. (TSLA)
Signal Sigma PT: $180 (Raised from $170), 0% CAGR
Analyst PT: $186
Upside: ~2%
Rating: HOLD
Assumptions:
16% Revenue Growth
17% Gross Margins
9% OpEx pct Sales
41 x EBITDA Multiple
Broadcom Inc (AVGO)
Signal Sigma PT: $1411 (Lowered from $1470), 20% CAGR
Analyst PT: $1600
Upside: ~4%
Rating: BUY
Assumptions:
15% Revenue Growth
70% Gross Margins
23% OpEx pct Sales
30 x EBITDA Multiple
General Observations
Before we create the 3 fundamental scenarios for the market (optimistic, neutral and pessimistic), we’d like to cover some observations drawn from working on the models.
Momentum is a force to be reckoned with
Not only has momentum carried the equity market from a technical standpoint, but fundamental projections are impacted as well. This is good news to a certain extent. We’re fairly convinced that our target for META is fairly high, while our target for TSLA is probably too conservative. Since our models rely on past information in order to generate projections, they rely on the assumption that previous trends will continue (in most cases, they do!). Technicals and fundamentals currently align as long as…
…EPS actually grows.
There’s no denying current valuations are stretched. The equity market will need to produce results in terms of actual EPS Growth, since the expansion of multiples has run its course. Now, corporations will need to generate profits and prove why their stocks are so historically expensive.
One more thing
Interest rates. Ideally, we’ll get slightly lower interest rates next year (think -1.5%), but not dramatically lower. Lower interest rates align with a “soft landing” narrative, and would help move capital away from treasuries and into the stock market (remember TINA? - “there is no alternative” - from a couple of years ago?).
Dramatically lower rates would spell trouble, as they would most likely come about due to a recession. The equity market is better equipped to handle high interest rates in a growth environment than a full on recession that makes all growth projections go out the window.
S&P 500 Valuation and Summary of Models for Q2 2025 (Base Case)
It’s time to combine the risk-reward for analyzed stocks into a single number that we can use as a proxy for the whole market. This will serve as the basis of our analysis going forward.
Combined Upside: 11.30%
SPY Close Price: $523
SPY 1 Year Price Target: $582, at 20% Compound Annual Growth Rate
Note: the Price Target reflects expectations for summer (Q2) of 2025, not year-end 2025
Market Scenarios
SPY Optimistic Scenario (A) - 50% Probability
The optimistic scenario is the one sell-side analysts currently envision. There is no recession in the following 12 months, revenue growth continues and translates into actual EPS Growth. CEOs continue to provide optimistic projections into the future, so high valuations are maintained.
S&P 500 Earnings per Share: $255
Valuation Multiple: 22.8 x
SPY Median Price Target: $582 (Q2 2025)
Price Range (+/- 1 STD): $643 - $525
CAGR: 20%
ODDS: 50%
SPY Neutral Scenario (B) - 45% Probability
In a neutral scenario, growth occurs at a reasonable rate and does not accelerate further. This scenario pits investors against an uncomfortable truth: that stocks are currently priced for perfection and may suffer flat-to-lower performance for the next 12 months. There’s nothing that goes “wrong” in particular - valuations are simply too high and won’t be entirely justified.
S&P 500 Earnings per Share: $245
Valuation Multiple: 22.04
SPY Median Price Target: $540 (Q2 2025)
Price Range (+/- 1 STD): $597 - $487
CAGR: 14%
ODDS: 45%
SPY Pessimistic Scenario (C) - 5% Probability
In a pessimistic scenario, there is no EPS growth at all in the coming year. Neither is there an actual recession. Valuations revert to the cycle mean (21) and the advance in 2024 is nothing but a bubble.
Technically, this scenario does not make sense, as the price action is indicating a completely different outcome.
S&P 500 Earnings per Share: $200
Valuation Multiple: 21
SPY Median Price Target: $420 (Q2 2025)
Price Range (+/- 1 STD): $464 - $379
CAGR: 0%
ODDS: 5%
Conclusions
So which one is it going to be? Scenario A, B, or C presented above? As repeated many times, our job is not to attempt to make predictions, but to manage risk. Let’s explore what Wall Street analysts are currently projecting and if they are in agreement with our targets. As of May 20, 2024, these are the official S&P 500 price targets for year-end 2024:
Broadly speaking, 5 institutions are in agreement with Scenario A, 9 are aligned with Scenario B and JP Morgan is the sole firm predicting the bearish Scenario C.
Whichever scenario prevails, our framework allows for efficient and clear decision making. Our own bias is optimistic, simply because the street appears to be inclined more toward conservative numbers. Andrew Greenebaum, senior vice president of equity research product management at Jefferies notes:
However, since 2000, the future performance of the S&P 500 is "quite good" when Wall Street is forecasting downside, with the average performance over the next six months sitting at 6.3% and the returns over the following 12 months reaching a cushy 13%… -Andrew Greenebaum
Similar to our findings of an 11% upside when using a bottom-up analysis approach, John Butters, senior earnings analyst at FactSet agrees:
Feel free to reach out if you need any help with your portfolio or investing strategy! And thank you again for supporting Signal Sigma!
Andrei Sota