Markets and Fundamentals: The Evidence  105
The fundamental performance of companies and of the economy also ex-
plains the level of the stock market over shorter periods of time. We estimated 
a fundamental P/E for the U.S. stock market for each year from 1962 to 2019, 
using the simplest equity discounted-cash-flow (DCF) valuation model, fol-
lowing the value driver formula first presented in Chapter 2. We estimated 
what the price-to-earnings ratios would have been for the U.S. stock market 
for each year, had they been based on these fundamental economic factors. 
Exhibit 7.5 shows how well even a simple fundamental valuation model fits 
the stock market’s actual P/E levels over the past decades, despite periods of 
extremely high economic growth in the 1960s and 1990s, as well as periods of 
low growth and high inflation in the 1970s and 1980s. By and large, the U.S. 
stock market has been fairly priced and in general has oscillated around its 
fundamental P/Es. We conducted a similar analysis of the European stock 
markets and obtained similar results. 
Note that both the fundamental and actual P/Es have shown an upward 
trend over the past 35 years, rising toward 17 in 2019. To a large extent, this 
pattern is driven by steadily increasing margins and returns on capital.9 Ex-
cess cash balances held by large companies form another factor. Cash has a 
high implied P/E because it carries little after-tax interest. Correcting for the 
excess cash balance in corporate P/Es lowers the 2017 ratio for the market as 
a whole by a full point, from 19 to 18.10
9 See also Chapter 8 and R. Jain, B. Jiang, and T. Koller, “What’s behind This Year’s Buoyant Market,” 
McKinsey on Finance, no. 52 (Autumn 2014): 27–31.
EXHIBIT 7.5  Estimating Fundamental Market Valuation Levels
P/E ratio1
0
5
10
15
20
25
30
1962
1967
1972
1977
1982
1987
1992
1997
2002
2007
2012
2017
Fundamental2
Median
Aggregate
1 Price-to-earnings ratio on 12-month forward-looking earnings for S&P 500.
2 Moving average over three years.
10 See R. Gupta, B. Jiang, and T. Koller, “Looking behind the Numbers for US Stock Indexes,” McKinsey 
on Finance, no. 65 (January 2018): 11–15.

106 The STock MarkeT IS SMarTer Than You ThInk
 higher returns, higher value 
 What holds for the stock market as a whole also holds across industries. For 
the largest listed companies in the world grouped by industry in 2018, 11 we 
took their average ROIC for the previous three years as a proxy for expected 
future returns and used the analysts’ consensus estimate of their three-year 
growth outlook as the proxy for long-term expected growth (see Exhibit 7.6 ). 
Industries with higher ratios of market value to capital or market value to 
earnings also have higher growth and/or higher ROIC driven by better sales 
margins and capital turnover. Life science and technology companies had the 
highest valuation levels, thanks to having the highest ROIC combined with 
superior growth. Other companies, like those in the hotels and restaurants or 
luxury-goods sectors, receive high valuations from strong growth at average 
 EXHIBIT  7.6 Market Value vs. ROIC and Growth across Selected Industry Sectors 
Global companies with real revenues > $1 billlion, 2018 median
Biotechnology
Health-care equipment and supplies
Information services and software
Pharmaceuticals
Aerospace and defense
Hotels, restaurants, and leisure
Luxury goods and apparel
Branded consumer goods
Household durables
Machinery and equipment
Technology hardware
Retailing
Chemicals
Transportation and logistics
Automobiles and parts
Construction
Distribution and trading
Airlines
Metals and mining
Utilities and power producers
11.5
Market value/capital1
Market value/
earnings1
ROIC,2 %
Growth,3 %  
8.5
7.5
5.5
3.6
3.5
3.3
3.1
2.3
2.3
2.2
2.2
1.9
1.7
1.6
1.6
1.5
1.5
1.4
1.3
13.9
15.6
13.1
12.0
13.0
11.2
10.3
11.3
9.4
11.1
9.1
9.8
9.1
10.2
6.5
8.5
9.3
6.7
7.6
9.8
38.7
31.6
47.6
23.7
13.5
15.7
16.8
14.8
15.9
11.3
13.2
13.1
10.8
8.2
11.2
10.4
7.8
10.9
6.9
6.0 
9.3
6.1
6.2
5.1
5.2
5.6
5.2
3.6
4.7
5.0
5.0
4.9
4.2
4.5
4.6
4.3
4.6
3.7
3.3
2.9
1 Market value is enterprise value, capital is invested capital excluding goodwill, and earnings is earnings before interest, taxes, depreciation, and amortization 
(EBITDA).
2 Average return on invested capital excluding goodwill over 2015–2017.
3 Analyst consensus forecast of annual revenue growth from 2018 to 2020.
 Source: Corporate Performance Analytics by McKinsey.
11 This sample comprises all listed companies (excluding fi nancial institutions) with revenues exceed-
ing $1 billion from the United States, Europe, Australia, New Zealand, and Japan.