Even at an All-Time High, The Vanguard S&P 500 ETF Isn't as Expensive as It Seems

Key Points

• The S&P 500 has gotten more expensive because of outsized gains in recent years.

• The index is much more growth-oriented than in the past, which helps justify a higher valuation.

• The S&P 500's composition has also made it less diversified and more prone to volatility.

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Exchange-traded funds (ETFs) can provide low-cost ways to get exposure to a diversified basket of stocks. With over $1.5 trillion in assets, the Vanguard S&P 500 ETF (NYSEMKT: VOO) is the largest S&P 500 (SNPINDEX: ^GSPC) fund by net assets -- even larger than the iShares Core S&P 500 ETF and the SPDR S&P 500 ETF Trust .

The Vanguard S&P 500 ETF is hovering around an all-time high at the time of this writing -- up 8.5% year to date and a whopping 66.4% since the start of 2023. But S&P 500 earnings haven't grown nearly as fast, which has pushed up the valuation of the index.

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Here's why the S&P 500 isn't as expensive as it seems, including a few reasons why it could still be a good buy at an all-time high.

Image source: Getty Images.

Understanding the S&P 500's valuation

One simple way to measure the S&P 500's valuation is to look at the price appreciation of the index compared to changes in its operating earnings per share (EPS). Operating earnings can be a better metric for tracking the valuation of the S&P 500 because they exclude one-time charges or gains that don't accurately represent the performance of the underlying businesses.

Here's a look at how the S&P 500 has traded in comparison to its operating EPS over different intervals.

Data source: YCharts.

As you can see in the table, the S&P 500 is rising faster than operating earnings, which has expanded its valuation. Overall, the businesses that make up the S&P 500 are relatively expensive based on their performance.

Another way of looking at S&P 500 valuation is forward earnings projections. The forward price-to-earnings (P/E) ratio of the S&P 500 takes the current price and divides it by analyst consensus estimates for earnings over the next year rather than the trailing 12 months.

According to data from FactSet from Aug. 1, the forward P/E ratio of the S&P 500 is 22.2 compared to a five-year average forward P/E of 19.9 and a 10-year average forward P/E of 18.5. So the S&P 500 commands a 20% premium to its 10-year average. On the surface, it looks like the index is massively overvalued. However, the valuation of the S&P 500 and companies in general should arguably go up over time as companies become more efficient.

In defense of valuation expansion

The internet and the instant transfer of information have made doing business much more efficient. Just think about the time savings from sending an email versus a fax or hopping on a video call instead of traveling to meet in person. Then, there is also the transition from having several analog devices performing independent tasks -- like an alarm clock or calculator -- to having many tools available at arm's reach, all on a single mobile phone.

Artificial intelligence (AI) should further increase worker productivity, and in turn, boost company performance. As companies across industries become better businesses, the overall valuation of the market should steadily tick higher.

It is natural for the valuation of the S&P 500 to rise over time as growth-focused companies make up a larger portion of the index. Companies that reinvest their profits rather than distributing them to shareholders through buybacks and dividends should command higher valuations as those investments generate returns.

Pros and cons of a growth-oriented stock market

It's not the best idea to glance at what the valuation of the S&P 500 is today versus the average of the last decade and hastily assume the S&P 500 is overvalued without considering the valid reasons why the index is more expensive. By the same token, it's a mistake to gloss over the risks of today's market.

Growth-driven companies have increased the quality of S&P 500 earnings and the projected growth rate, but they can also boost market volatility. A cyclical downturn in investment in the tech sector would have a sizable impact on the S&P 500, more so than when tech had a lower weight in the index.

All told, the S&P 500 deserves to have a higher than historical valuation, so the ETFs that track the index aren't as expensive as they seem. However, don't be surprised if the index makes sharper moves to the upside and the downside, given its composition.

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Daniel Foelber has positions in Nvidia. The Motley Fool has positions in and recommends Nvidia and Vanguard S&P 500 ETF. The Motley Fool has a disclosure policy.