Markets and Fundamentals: The Evidence  107
levels of ROIC. Utilities and companies in metals and mining were valued at 
low market-value-to-capital multiples because of their low returns on capital 
and low expected growth. Note that the ratios of market value to earnings 
show less variation across sectors, reflecting investor expectations of converg-
ing earnings growth in the long term.
The same principles apply to individual companies. We compared the ratios 
of market value to capital of all the companies in the same sample versus their 
expected ROIC and growth. Exhibit 7.7 shows that, for a given level of growth, 
higher rates of ROIC generally lead to higher market values, and above a given 
level of ROIC, higher growth also leads to higher value. Although the empirical 
results do not fit the theoretical model perfectly, they still clearly demonstrate 
that the market values companies based on growth and ROIC.
For example, consider the fact that valuation multiples in the United 
States tend to be higher than in most other countries. That fact has even 
made some European companies consider relisting their stocks in the U.S. 
stock market in the hope of obtaining a higher valuation. As we discuss later 
in this chapter, however, such hope is false. U.S. investors do not pay more 
than European investors for the same stock. The difference in valuation mul-
tiples can be explained by underlying fundamentals. First, there is a marked 
difference in sector composition between the U.S and European economies. 
The technology and life science sectors, which have high valuation multiples, 
carry far more weight in the U.S. economy. Second, we find that U.S. compa-
nies typically generate higher returns on capital than European companies 
in the same sector.
EXHIBIT 7.7  Market Value, ROIC, and Growth: Empirical Relationship
Global companies with real revenues > $1 billlion
Market value/capital,1 2018, median
Growth,3 %
Market value/earnings,1 2018, median
Growth,3 %
12
10
8
6
4
2
0
<0
>10
0–2.5
2.5–5
5–7.5 7.5–10
>30
10–20
<10
20–30
12
10
8
6
4
2
0
<0
>10
0–2.5
2.5–5
5–7.5 7.5–10
>30
10–20
<10
20–30
ROIC,2 %
ROIC,2 %
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 2016–2017.
3 Analyst consensus forecast of annual earnings growth from 2018 to 2020.
Source: Corporate Performance Analytics by McKinsey.

108  The Stock Market Is Smarter Than You Think
Deviations from Fundamentals
Nevertheless, there have been periods when deviations from economic fun-
damentals were so significant and widespread that they affected the stock 
market as a whole. Two examples are the technology bubble that burst in 2000 
and the credit bubble that collapsed in 2007 (see Exhibit 7.8).
The technology market boom is a classic example of a valuation bubble, in 
which stocks are priced at earnings multiples that underlying fundamentals 
cannot justify. When Netscape Communications became a public company in 
1995, it saw its market capitalization soar to $6 billion on an annual revenue 
base of just $85 million. As investors quickly became convinced that the Inter-
net would change the world, they sent the Standard & Poor’s (S&P) 500 index 
to a new peak in 2000. By 2003, the index had tumbled back to half that level.
Although the valuation of the market overall was affected, the technology 
bubble was concentrated in technology stocks and certain very large stocks 
(so-called megacaps) in other sectors. Before and after the bubble, the P/Es of 
the 30 largest companies were about the same on average as those of the other 
470 companies in the index (see Exhibit 7.9). However, in 1999, the average 
EXHIBIT 7.8  U.S. and European Equity Markets in High-Tech and Credit Bubbles
U.S. and European total return index (January 1991 = 100)
S&P 500
$
1,400
1,600
1,200
1,000
800
600
400
200
0
Jan 1991
Jan 1993
Jan 1995
Jan 1997
Jan 1999
Jan 2001
Jan 2003
Jan 2005
Jan 2007
Jan 2009
Jan 2011
Jan 2013
Jan 2015
Jan 2017
Jan 2019
Sep 2000
Oct 2007
FTSE Eurofirst 300
€
1,400
1,600
1,200
1,000
800
600
400
200
0
Jan 1991
Jan 1993
Jan 1995
Jan 1997
Jan 1999
Jan 2001
Jan 2003
Jan 2005
Jan 2007
Jan 2009
Jan 2011
Jan 2013
Jan 2015
Jan 2017
Jan 2019
Sep 2000
Oct 2007
Source: S&P Capital IQ.
EXHIBIT 7.9  Impact of Largest Stocks on Overall Market Valuation
12-month trailing price-to-earnings ratios
30
23
46
15
15
9
9
24
28
15
9
P/E of remaining companies
P/E of 30 largest companies
P/E for S&P overall
25
1980
1990
1999
2001
Source: Compustat.