Discover the story behind two attempts to value soaraway US stocks
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At first glance, US stocks look fully valued based on traditional valuation metrics like the PE (price to earnings) ratio, but a new study by researchers at the Federal Reserve of Minneapolis suggests equity markets may be somewhat less expensive than generally thought.
This article ‘unpacks’ the new research to explain the key differences between the data used by both approaches. If the new research holds water, it could have big implications for stock markets and future investment returns.
What are traditional valuation models saying?
Looking through the lens of traditional valuation metrics like economist Robert Shiller’s CAPE (cyclically adjusted price to earnings) ratio, the US market is sitting on a ratio of 40 times, close to its highest ever mark of 44 times, hit in December 1999, during the dotcom era.
The CAPE differs from the PE ratio in that it uses 10-year average earnings instead of last year’s or next years expected earnings. Earnings are then adjusted for inflation.
Dividends are another popular way to look at valuation although the increased use of share buybacks in recent years may have reduced their usefulness.
Nevertheless, the message is the same as seen from the PE ratio with the current dividend yield of the S&P 500 sitting at 1.1%, matching the lowest ever yield achieved in August 2000.
Shiller has also created a measure called the Excess CAPE Yield, which subtracts the 10-year bond yield from the earnings yield, calculated by taking the inverse of the PE ratio.
As Shiller points out, this measure of value has offered a great guide to how equities have fared over the ensuing decade. The current reading of around 1% implies US stocks are priced to deliver a miniscule 1% average annual return over the next 10 years.
For context, US stocks have delivered close to 15% average annual returns over the last decade, which was only eclipsed in the 1950s when the market delivered close to 20% annual returns. Over the last 100 years, stocks have delivered average returns of around 9% a year.
What about forward-looking measures?
Critics point out the Shiller PE is too backward looking. It can be argued that because businesses change, earnings from 10 years ago have little relevance to investors today. The stock market is forward looking, trying to figure out what might happen in the next decade.
One way to address this perceived drawback is to use the forward PE, which is based on consensus analysts’ earnings estimates for the next 12-months.
From a low of under eight times in 2008, the forward PE has more than doubled to sit close to around 22 times, just under the all-time peak of just over 24 times reached in January 2000.
Unlike the CAPE, which dates to 1871, data for the forward PE only goes back to 1985. Although it varies to an extent it still largely gives the same ‘stretched’ valuations message as the CAPE and dividend yield.
What is different about the latest research?
Researchers from the Minneapolis Fed used macroeconomic data sourced from the IMA (Integrated Macroeconomic Accounts).
This is a big undertaking involving crunching data collected by the BEA (Bureau of Economic Analysis) and the FRB (Federal Reserve Board) from households, businesses and government.
They authors say this has the advantage of being a more detailed historical record of the economic factors which drive changes in free cash flow to shareholders, that isn’t available from financial accounting data for public firms.
Importantly it includes the entire US corporate sector not just that component of it which is listed on the stock market.
One downside of using national macroeconomic data is that it is not very timely, with the latest readings being late 2022.
The research focuses on free cash flow to enterprise valuation rather than earnings. Divide free cash flow by enterprise value and express it as a percentage (multiply by 100) to arrive at a free cash flow yield.
This is like the upside-down PE ratio we introduced earlier, except using free cash flow instead of earnings.
Annual free cash flow is the money generated by a business after deducting all operating costs, interest payments and investments to maintain or grow the business.
Free cash flow can be ‘lumpier’ than reported earnings which are designed to smooth expenditures like investments.
Enterprise value is the market value adjusted for debt and other liabilities. It represents the total value a buyer of company would need to pay.
The researchers show there is little difference between the two methodologies when looking at earnings-based metrics but using their version of free cash yield paints a less extreme picture of market overvaluation.
The chart shows that the free cash flow yield, while at the lower end of the spectrum, is about the same level as it was in 1982. One standard deviation is a statistical measure of how far something is from its average.
The reading in late 2022 was just shy of one standard deviation below the average which means it was within the realms of what might be expected during normal ebbs and flow in the data due to the economic cycle.
Why is the free cash flow yield not as extreme as the earnings yield?
The research paper suggests the different results stem from a greater proportion of free cash flow ending up in shareholders pockets than implied by earnings measures.
For example, free cash flow has increased from 4% of total cash generated in 1980 to 12% in 2022.
The researchers believe this can be explained by a combination of a smaller amount of cash being paid to employees and companies forking out less in capital expenditures.
In other words, employees have taken a smaller share of the economic pie, and the pie has been able to expand with a lower investment since 1982.
This could be explained by a rise in intangible assets relative to tangible or physical assets. Something which has been a feature of the corporate landscape over the past few decades. Tangible assets are things like buildings, factories and machinery.
Intangibles are things you cannot touch like brand names, client relationships, patents, installed databases and distribution networks. Intangibles are difficult to place a value on and hard to replicate from a competitive standpoint.
The dominance of big technology companies
The authors of the paper suggest one other intriguing explanation for lower investment spending, namely a big increase in monopoly power in recent decades.
This points the finger at big technology companies which have enjoyed a period of unencumbered strong growth and influence.
The Magnificent Seven (Apple, Alphabet, Amazon, Meta, and Tesla) have seen their collective market value in the S&P 500 index more than double from 16% in 2016 to around a third, a record concentration level.
One feature driving the rise of these companies has been their strong free cash flow, due to ‘asset light’ business models.
This has changed dramatically since the arrival of AI with the combined capital expenditures of the hyperscalers projected to exceed $700 billion in 2026.
Could falling free cash flows change the valuation picture?
Since the Fed paper data is limited to late 2022, we do not yet know how the picture could have changed due to the acceleration in AI investments seen over the last two years.
That said, given the technology firms represent such a significant proportion of the total free cash flow in the S&P 500, it seems reasonable to assume the free cash flow yield has dropped further since 2022.
Historically these firms have spent 12% to 15% of revenues on capital expenditures. In 2026 capital intensity is expected to hit 33% to 45% of revenues, some of the highest rates since the dotcom era in the late 1990s.
As the table shows, this will likely squeeze their combined free cash flow which is projected to drop by nearly a third in 2026 and by a further 10% in 2027.
The new research is interesting from the perspective of understanding free cash flows and their changing composition. While the free cash flow yield in 2022 was not as extreme as the earnings yield, it was still the lowest level seen in since the dotcom boom.
Martin Gamble: Shares and Markets Writer
Martin Gamble is Shares and Markets writer at AJ Bell. He was previously the Education Editor of Shares Magazine. He has been with the business since 2019.
Martin graduated from the University of Kent in...
