What Earnings Multiples Aren't Telling Us

Ask most market watchers why the US equity market had such a good first half of 2026, despite some clear headwinds (the war in Iran, rising oil prices, rising bond yields, more hawkish central banks; the list goes on) and you'll likely get a version of the same answer: spectacular earnings growth.

This is completely true. As the dark blue line in the chart below shows, the price/earnings ratio of the S&P 500 has fallen back below 20x despite the market’s recent strong performance, as consensus forward earnings expectations have risen more than a third over the last year.

However, this doesn’t tell the whole story. If you look at cash profits, instead of accounting ones, the picture is somewhat less benign. Free cash flow (FCF) is a measure of the actual cash generated by a company’s operations, less the amount of cash it spends buying or building long-term assets (known as capital expenditure, or capex).

The light blue line in the chart shows the valuation multiple of the S&P 500 when viewed through the lens of FCF, not accounting earnings. As is clear from the chart, these metrics used to track each other closely (which makes sense, as accounting profits can be thought of as ‘smoothed’ cash profits). Over the last couple of years however, the two lines have pulled apart. The index still trades above 25 times its FCF, and the gap to the earnings multiple has ballooned.

No deep investigative reporting is required to find the culprit: capital expenditure, concentrated in a handful of technology companies known as ‘hyperscalers’, has exploded. We went into this phenomenon in some detail in two pieces published in May titled Are AI Related Earnings Being Flattered? and The Arithmetic of the AI Capex Boom and we won’t rehash the details here. The key point is that anyone using a P/E multiple alone to argue the index is reasonably priced is implicitly assuming that today's capex converts to tomorrow's earnings at a healthy return. This may or may not happen, but we think this is an assumption worth stating explicitly, especially if you’re pinning your hopes for further US market performance on continued earnings growth. 

EFJR

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