Measuring intangible assets is a major accounting challenge. Free cash flow sidesteps this problem because it simply measures cash left after all bills are paid, regardless of whether spending on intangibles is classified as an input cost or as a capital expenditure.
Traditional Price-to-Earnings ratios suggest an overvalued market, as they have drifted up for decades. However, the ratio of market value to free cash flow has remained stable and within historical norms, offering a contrarian perspective on current equity valuations.
Previous technological shifts primarily automated low-skill jobs, widening inequality. AI, however, is poised to replace or augment tasks done by high-earning knowledge workers. This could lead to a compression of the wage distribution, a reversal of historical trends driven by technology.
In the early 1980s, stock prices were low because investors foresaw the coming IT revolution but were unsure which companies would win or lose. This created broad uncertainty, depressing incumbent valuations—a historical parallel to the current market trying to price the impact of AI.
The puzzle of persistently high stock market valuations can be illuminated by macroeconomic factors. For instance, the long-term decline in labor's share of national output directly translates into higher corporate profits and, consequently, higher valuations for firms, bridging the gap between macro and finance.
Free cash flow has outpaced earnings growth primarily for two reasons: a smaller share of corporate output is going to labor wages, and firms have been able to generate profits without significant capital expenditure. This surplus cash flows directly to shareholders, boosting valuations.
For years, tech giants generated massive free cash flow with minimal capital investment, supporting high stock prices. The current AI boom requires enormous spending on data centers and hardware, reversing this dynamic and creating new risks for investors if the spending doesn't yield proportionate returns.
The decline in the U.S. net foreign asset position is often attributed solely to trade deficits. However, a major driver was the appreciation of foreign investments in the U.S. equity market, which outperformed global markets and thus increased the value of U.S. liabilities to the world.