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Are stocks overvalued? By many financial measures, U.S. stock prices look bloated—or, at least, well off their historical averages. Consider the popular price-to-earnings metrics published by economist Robert Shiller (developed in his work with John Campbell). As stock price indexes set new records, reported corporate earnings have risen more slowly, and the earnings-to-price ratio is flirting with historic lows (Figure 1).
Shiller’s ratio is inverted in Figure 1 to facilitate direct comparison with new findings from Minneapolis Fed monetary advisors Jonathan Heathcote and Fabrizio Perri and bank consultant Andrew Atkeson of UCLA (Staff Report 682, “A Macroeconomic Perspective on Stock Market Valuation Ratios”). The economists set aside corporate shareholder reports for macroeconomic data. And they favor a different statistic to capture how modern investors value companies: “free cash flow,” a broad measure of all cash available to pay out to owners—a residual quantity that reflects much more than just reported earnings.
Through this lens, the enterprise value of U.S. companies (the macroeconomic expression of investors’ valuation of all corporate entities, public and private) appears historically consistent with the amount of cash those companies are generating (Figure 2).
The economists do note the sharp decline in free cash flow yield since 2023, although the series remains within close range of its average value since World War II. While they do not discuss contemporary events in the staff report, Heathcote discussed in a Bloomberg podcast how this recent drop in cash flow yield coincides with the surge in investment in artificial intelligence data centers.
Building on data series constructed in their complementary research, Atkeson, Heathcote, and Perri illustrate how macroeconomic data (via the integrated macroeconomic accounts published by the Federal Reserve Board) can rationalize the behavior of investors. They argue that financial data alone tell an increasingly misleading story as corporations have evolved to compensate owners in new ways. “Persistently low earnings yields need not reflect mispricing, bubbles, or unusually low discount rates,” they write. Reported earnings and free cash flow—which is experienced by investors if not formally broken out in corporate filings—are related but increasingly diverging. And investors appear to care principally about the cash. As cash flow has grown, the valuations of U.S. companies have soared even as corporate output has grown much more slowly.
Through a series of accounting transformations and decompositions, the economists identify the trends in the fundamental factors of production—labor and capital—that have accompanied the growth in free cash flow. On labor, they find that today a much larger share of corporate output now flows to owners rather than workers. “As a matter of accounting,” they write, “the roughly 8 percentage point increase in the fraction of corporate output going to free cash flow from the early 1980s until the present is explained by an 8 percentage point decline in the share of value added going to labor.” Some of this shift could be attributed to changes in how some high-skilled employees are compensated via equity stakes in the companies they work for. But it could also reflect the rise in “factorless income” (income clearly accruing to neither labor nor capital) that flows to firm owners that enjoy a degree of monopoly power.
On capital, the divergence between earnings and free cash flow corresponds to changes in observable, measured capital investment. The economists find that between 1980 and 2022, the measured capital of U.S. companies fell dramatically as a share of enterprise value, from 144 percent to 44 percent. One interpretation of this history is that “corporations have been able to generate growth in earnings without increasing the share of corporate value added devoted to measured investment,” they write. “As corporations have paid out an increasing fraction of their earnings, free cash flow has naturally grown faster than earnings.”
An increase in investment in intangible capital—hard-to-quantify assets like reputation, expertise, data, or proprietary software—might partly explain why measured capital and investment have remained flat while valuations boom. The economists leave for future work a detailed investigation of the factors behind the capital and labor trends revealed by macroeconomic data. For this paper, it is sufficient and significant to document an evident shift in corporate structure and behavior that reassures investors of future cash flow, even as earnings and measured investment grow much more slowly by comparison.
If Atkeson, Heathcote, and Perri are right, it might be time to leave obsolete financial indicators behind. “We should not expect traditional stock market valuation metrics other than free cash flow yield to return to their historical means,” they write.
Read the Minneapolis Fed staff report: “A Macroeconomic Perspective on Stock Market Valuation Ratios”
Jeff Horwich is the senior economics writer for the Minneapolis Fed. He has been an economic journalist with public radio, commissioned examiner for the Consumer Financial Protection Bureau, and director of policy and communications for the Minneapolis Public Housing Authority. He received his master’s degree in applied economics from the University of Minnesota.
