Absolute equity valuations enter new territory and FCF considerations

Equity valuations do not live in isolation

While the trailing valuation metrics are a bit distorted for a couple of quarters more, the forward-looking metrics are less impacted by sudden changes in earnings power. Here we also observe US equities and global equities being expensive in an absolute perspective with US equities close to the same levels as in 2000 during the dot-com bubble. However, with bond yields also at record low levels it is not strange that we observe high equity valuations as equities interact with other asset classes, and more specifically the bond market. The current free cash flow yield on global equities is 4.7% which is still attractive compared to the global bond market and as a result we are still positive on the equity market although the inflationary pressure could quickly change the picture.

If we compare the popular Nasdaq 100 Index with corporate investment-grade bonds, then we see that US technology stocks have been a lot more expensive in absolute terms and in relative terms to credit bonds. The current free cash flow yield on Nasdaq 100 is 2.8% and is thus much more expensive than global equities which is a result of higher profitability and return on capital, combined with much higher growth rates. The spread between the free cash flow yield and the global credit yield is coming down again to levels not seen since October 2018. This is reflecting a very strong outlook for credit quality and earnings growth driven by large fiscal stimulus. When we look at Nasdaq 100 and compare it to credit bonds and the global equity market there are reasons to begin being worried about whether investors are paying too much for future growth.

We had a listener of our podcast commenting on our free cash flow comments that we have been making over the past year. The person had two objections to our methodology, 1) we are not adjusting for stock options which are massively used by technology companies to attract talent and reduce the cash burn rate, and 2) we are not adjusting free cash flow for acquisitions which many technology companies are doing instead of investing in R&D themselves.

The objection is true, and the free cash flow should be corrected by stock options and warrants. But how big a difference does it make? Many of the largest constituents in the Nasdaq 100 Index have stock options corresponding to around 1-4% dilution of the current outstanding shares and thus including this dilution would make the metric more correct, but it would not alter the overall conclusion.

The second objection is interesting. Industry practice suggests to only subtract capital expenditures from the operating cash flow to get to the free cash flow (the cash flow that is available for acquisitions, debt reduction, buybacks of own shares, or dividends), because it is more stable and provides a more realistic picture of the underlying free cash flow generation. Large acquisition or divestments would make the free cash flow yield very volatile and clutter the analysis. The adjustment for acquisitions makes sense if an investor could expect acquisitions to be consistent, but that is very rare for most companies and as such we acknowledge the potential adjustment, but we do find it adds value for the investment decision process on equity indices.