Stocks haven\u2019t looked this overpriced in 20 years, one Wall Street economist wrote this past week. He cites the 10-year Treasury yield, recently up to about 5%, compared with the \u201cearnings yield\u201d of the S&P 500 index, or the price\/earnings ratio flipped upside down, which is also near 5%. As finance poindexters say, has the equity risk premium collapsed to zero? That roughly translates to: Why take a chance on risky stocks when safe bonds seem similarly priced? <\/p>\n
The bull response is that Treasury coupons are fixed, whereas company earnings tend to grow, so for long-termers, safe bonds aren\u2019t really on par with stocks. Also, rising bond yields like we\u2019ve seen are commonly assumed to nudge stock valuations lower. But maybe they don\u2019t, if the rising yields are a sign of a peppy economy and better earnings to come. BofA Securities points out that since 1945, the correlation between rising real yields and falling P\/E ratios has been weak, and negative. Stick with stocks, in other words. <\/p>\n
I guess so. But also, if you broke up with bonds a few years ago when that 10-year Treasury yield was a fraction of 1%, or if the recent outperformance of stocks over bonds has left you too stock-heavy, maybe raise your bond mix back to more ordinary levels.<\/p>\n
Let\u2019s focus on another point the bulls make about the S&P 500\u2019s valuation. It has been driven higher by recent gains for seven tech giants that carry the most sway in the index\u2014or that did until this past week, when
\n Tesla
\n (ticker: TSLA) had an earnings oopsie-daisy, and fell behind
\n Berkshire Hathaway
\n (BRK.B). More on that in a moment. <\/p>\n
The others are
\n Microsoft
\n (MSFT),
\n Alphabet
\n (GOOGL),
\n Amazon.com
\n (AMZN), and
\n Meta Platforms
\n (META), which report results in the week ahead;
\n Apple
\n (AAPL), which is up the following week; and
\n Nvidia
\n (NVDA), which reports closer to Thanksgiving. The P\/E ratio for the seven has climbed from 29 to 45 this year. Are they in a bubble? <\/p>\n
Wall Street has a way to tell. It\u2019s called discounted cash flow, or DCF analysis, and it\u2019s the basis for analyst price targets and Buy, Hold, and Sell ratings. <\/p>\n
Step 1: Predict precise free cash flows far into the future, say 10 years, even though Wall Street routinely guesses wrong on much easier measures like revenue for the current quarter. <\/p>\n
Step 2: Choose what\u2019s called a discount rate, which is based in part on risk, which no one has figured out how to accurately measure for stocks in their four-century history. <\/p>\n
Step 3 onward: Use this made-up rate to calculate how much to pay today for those unknowable future cash flows. I\u2019m leaving out some important steps, like calculating a terminal value, which involves conjecture beyond year 10, and adjusting for distant, entirely theoretical debt levels. Don\u2019t forget to express your answer in the form of absolute certainty. <\/p>\n
Here\u2019s an alternative that\u2019s less mathy and more appropriately iffy. It doesn\u2019t have a high-finance-sounding name. I\u2019m considering \u201cdisgruntled crash-flop electrolysis,\u201d but I have to check the trademark status. DCFE involves starting with things we already know, like today\u2019s price, or can safely assume, like that an investor buying shares of one of these Big Tech companies would want to be decently rewarded\u2014say, with 12% yearly returns over the next five years. Ballpark how much free cash the company would have to be generating after those five years to be worth that price. And then sniff deeply at recent cash flow trends to decide whether such a thing is plausible, resulting in a rating of Yeah, Meh, or Nah. Think of it as a sanity check, not a market timing tool. <\/p>\n
Take Apple, the biggest of the bunch. A 12% yearly compounded return would take its recent $175 share price to just over $300 in five years. Based on today\u2019s market value and how the share count has been steadily declining, figure a future value of $4 trillion. At minimum, an investor might expect to see a 4% free-cash-flow yield on a mature business like that, or $160 billion a year. Not even oil monopoly Saudi Aramco is hitting those levels. <\/p>\n
But Apple is already over $100 billion in yearly free cash. And its capital spending isn\u2019t growing much. So even moderate revenue increases could leave it with a Brewster\u2019s Millions <\/em>situation where it\u2019s difficult to spend the cash. (Richard Pryor, John Candy, 1985, in which a minor league baseball player has to blow $30 million in 30 days to inherit $300 million.) I rate the stock a solid Meh, bordering on a Yeah. <\/p>\n Microsoft, Alphabet, and Amazon are three more companies with a path to joining the $100 billion free-cash-flow club at some point within the next several years, giving the U.S. the financial equivalent of four Aramcos. Amazon has much further to climb than the others, and all carry regulatory risk, but the idea is the same: Puttering around with the numbers, today\u2019s prices don\u2019t look ludicrous in light of the plausible path for free cash flow. Ditto for Meta, but on a smaller scale. Its management has stopped yammering about the metaverse, started yammering about artificial intelligence, and most important, slashed spending. Free cash flow could top $30 billion this year and approach $50 billion in several years. <\/p>\n Nvidia and Tesla are more difficult. Before the pandemic, Nvidia was generating free cash like a prosperous chip maker\u2014a few billion dollars a year. Its current value implies that within several years it will turn out a Meta-like $50 billion, or remain an incredibly fast grower, or both. It could happen\u2014the company has one of the strongest positions in AI\u2014but the assumptions are bold. And Tesla stock this past week skidded 9% in a day, after third-quarter results showed elevated discounting to sell vehicles. That makes the free-cash multiplication needed to justify the current price a leap. Nah for both.<\/p>\n On the whole, prices look elevated but not nuts. As for the equity risk premium, it\u2019s theoretical and ultimately unknowable, but I recently gave it an imaginary squeeze and it felt modestly positive. Which is good.<\/p>\n Write to <\/strong>Jack Hough at jack.hough@barrons.com. Follow him on Twitter<\/a> and subscribe to his Barron\u2019s Streetwise podcast.<\/p>\n<\/p><\/div>\n