The Wall Street Waltz: 90 Visual Perspectives, Illustrated Lessons From Financial Cycles and Trends, Revised and Updated Edition

Chart 7

Price/Cash Flow Ratios: A Hidden Twist

Do all stock market valuation measures indicate that stocks are currently drastically overpriced? Almost, but one that says there still may be room to rise is the ratio of the market's price to its cash flow. Cash flow is the sum of earnings plus depreciation. Depreciation comes from amortizing capital expenditures for plant and capacity over their estimated useful lives. Business has been pumping money into capital expenditures at record levels lately—contrary to public perceptions (see Chart 68)—so depreciation and cash flow also have been rising more than the public thinks.

This chart shows the price/cash flow ratio going back to 1945. While the market is far from bargain-basement levels by this standard, it's at levels that haven't always kept stocks from rising a lot further. Currently the market, this time measured by the S&P 400, is selling at 10 times its cash flow. The last time it sold at this price/cash flow ratio was in 1972 and 1973: from there the market was a disaster, losing 47 percent of its value in a year and a half. But going back further in history shows a different picture.

In 1948, the market sold at record lows of only five times cash flow. This low level indicated the market was ultracheap, and the market immediately began one of its biggest bull markets ever, rising threefold by 1958. As prices rose, so did the ratio—steadily—until 1961, where it hit an all-time peak of 12.5, far above the 1986 level of 10. ...