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Pro Analysis

Goldman Sachs: Profit metric means S&P worth 25% less

A technician inspects a silicon wafer at the Applied Materials Maydan Technology Center in Santa Clara, California.
David Paul Morris | Bloomberg | Getty Images
A technician inspects a silicon wafer at the Applied Materials Maydan Technology Center in Santa Clara, California.

Goldman Sachs believes the S&P 500 is expensive and worth 25 percent less based on a measure of profitability, but there are companies bucking the trend that should be bought, the investment bank told clients.

Slowing profits for the S&P 500 in the past eight quarters have reduced returned on equity (ROE) to just 14 percent, while the price to book (P/B) value, a pure valuation metric relative to a company's assets, has expanded above the 40-year average to 2.8 times, a divergence that in the past caused stocks to fall, according to Goldman.

"The historical relationship between ROE and P/B shows investors typically penalize falling profitability with lower valuation," wrote David Kostin, Goldman's chief U.S. equity strategist. "Based on history, an index-level ROE of 14 pecent implies a P/B of 2.1x, suggesting index downside of 25 percent."