Growth Stock Valuations Are Falling. Here’s Why

Full transcript:

Hello and welcome to this month’s market update for August 2026. My name is Steve Latham. I am the chief investment officer for Bernicke Wealth Management. Today we’re going to be talking about valuations in the S&P 500. And a lot of what we’ve been seeing over the last year or two has been discussions around how lofty valuations have been, primarily for a lot of those growth oriented, artificial intelligence linked companies.

However, that narrative is not necessarily true anymore. So we want to dive into some of the details as to why valuations are actually coming down for those growth oriented companies, and how that’s playing into the overall narrative of valuations going forward.

Comparing Valuations Across the S&P 500

Now we have a couple charts here in front of us on the left hand side. This is the valuations for a couple of different cohorts within the S&P 500.

So the green line represents the top ten stocks in the S&P 500. And their historical valuations going back to the mid 90s. The blue line is the remaining companies, the other 490 companies. And then the gray line is of course the S&P 500. And what we can see is that green line has been historically very volatile. Going back to the 2000, whenever we saw the dot-com bubble, of course those top names were becoming very highly valued to the point where they were all considered a bubble or in a bubble.

That bubble, of course, burst. And those valuations remained depressed throughout the teens till we started getting into the latter part of the teens and into the current decade, where valuations really started to ramp up, primarily starting from COVID. And then, of course, the artificial intelligence boom that we’ve been seeing and feeling for the last couple of years. However, that narrative, like I said before, is beginning to change where the top ten companies are now as valued or have the same valuations as the remaining 490 companies.

And this is something that we haven’t seen and since the mid-2010s. So if we look at those valuations at the top, the latest valuation reading is just shy of 20 times earnings for those top ten companies. The remaining is just above 19. And so your average is right around mid 19. That’s a very reasonable valuation range for most companies during a growth period.

Why Growth Valuations Are Coming Down

Of course we’re still seeing growth economically. We’re seeing consumers continuing to consume. And companies are are showing very strong growth numbers within their quarterly reports. So why are valuations coming down for those top ten companies. Well if we look over here on the right, we can see on a relative basis it’s not just the top ten company valuations that are coming down.

But the other value oriented company is not just the growth oriented companies but the value oriented companies. Those are your financial stocks, your energy stocks, utilities, materials industry. Those valuations have actually been coming up. And a lot of this has to do with the fundamentals of what’s been going on across the economy. So on a relative basis, whenever we look at that price to earnings ratio from growth oriented companies to value oriented companies, we actually find in historical terms, growth companies look better from a valuation perspective.

How Rising Bond Yields Raise the Cost of Capital

Now, there are some reasons why growth company valuations are coming down, one of which is because of yields. If we look at the chart here in front of us, again, this goes all the way back to the 50s. But we’re going to focus here. On the last ten or so years, we’ve seen a pretty clear trend where value, or excuse me, where yields have been increasing since COVID.

Now it’s been a little bit of a bumpy ride. And of course we’ve had inflation in the middle of that. But when we look at the bright blue line, that is the nominal yield of the ten year US Treasury bond. And that’s what you would get if you went out to buy a bond around today that’s currently yielding around 4.75%.

That’s relatively high for our recent historical standards. You have to go all the way back to pre financial crisis times to find a Treasury bond in the ten year range yielding that much. Now when you’re looking at that and you’re saying okay well what is actually happening in the context of valuations for companies, for growth companies, they are beginning to fund a lot of their growth through debt.

When you issue debt, you are going to price that debt or the yield that you have to deliver to the bondholders based off of what Treasury bonds are doing. So if Treasury bond yields are going up, then the price with which you need to price your debt is also going up. And that makes it more expensive for these growth companies to fund all the capital projects that they have.

Right now, a lot of that is geared towards artificial intelligence. And therefore, because it’s becoming more expensive, they have less capital with which to fund those projects. So naturally, valuations come down for growth companies whenever bond yields go up.

Now the other factor here is not just those longer term bond yields but bond yields across the spectrum. We’ve seen the shift happen in a relatively short order.

The light blue line here is what the yields were for each subsequent maturity, going from three months all the way over to 30 years. And as we saw at the end of last year, everything was lower. So all of the yields for every bond that you could purchase across the Treasury curve was lower. Everything has shifted higher. We call this a parallel shift of the yield curve since six months previous or seven months previous.

So if you look at the dark blue line, we see that every single point along the yield curve is now more expensive. So no matter if you’re trying to issue debt for short term projects, three, five, ten years, or longer term projects, anything beyond ten years, it’s becoming significantly more expensive. And again, your cost of capital increases as a result of that and the overall valuations that markets would place on your company go down because cash isn’t as freely available.

AI Spending and Shrinking Free Cash Flow

Now, the final piece of this, as we’ve been alluding to as well, is these growth companies have also been spending a lot of their free cash on artificial intelligence, because all of their free cash has been going back into investing in the company. There’s not a lot of cash left over, and in some cases, there’s no cash left over to either pay dividends or create a very robust, what they would call incredibly secure balance sheets for these large hyperscaling companies like Google, Amazon, Microsoft, so on and so forth.

A lot of the valuation historically has been on these companies’ ability to generate all this free cash flow, because they had so much cash on the balance sheet and the ability to generate cash through different economic periods of time, whether good or bad or otherwise, that’s made these companies very attractive for investors and therefore their valuations go up.

Well, now they’re spending all that cash and their free cash flow is coming down. So you don’t have that security, that ironclad blanket of a balance sheet to help during an economic storm. And the left hand chart here shows exactly how much these companies have been spending on artificial intelligence, specifically, the five artificial intelligence hyperscalers Google, Amazon, Meta, Microsoft and Oracle.

So just last year, they spent $416 billion. That’s up from the year prior of 241 billion and the year prior of 154 billion. So we’re seeing 70 to 80% increase in capital expenditures just on artificial intelligence. That trend is looking to continue for 2026 and into 2027, where the expectation is over $1 trillion across these five companies will be spent on artificial intelligence.

Now, of course, that money is coming from their standard operations, but it’s also coming from issuing debt like we talked about previously and, in some cases, issuing stock that is diluting of existing shareholders. Also a negative from a valuation perspective. And so if we just look at that cash flow over here on the right hand side, the blue line is what these companies are expecting in cash flow or what they have earned in cash flow.

The gray line is the free cash flow. So how much they have left over after they’ve spent all their money on keeping the lights on. And then the green line is how much they’re spending on those capital expenditures. So the simple math is blue line minus green line equals gray line. And again, up until around COVID, we saw a pretty healthy amount of free cash flow across these companies.

But those capital expenditures were slowly increasing. And then as soon as we got to artificial intelligence mania in 2023 and 2024, you start to see that exponentiate. And now we’re at a period where cash flow for some companies is actually negative and others it’s very bare bones. Again, that plays into why the growth valuations have been coming down, even though we’re at all time highs in the S&P 500 stock market or stock index.

And we’re seeing broad growth across other areas of the market.

So it’s one thing to say yep, valuations look great, it’s time to pile in, which some people might suggest that that would be a good opportunity because they have been coming down. But there are reasons for that. Specifically, higher yields creating a higher cost of capital for these growth companies, and less than stellar free cash flow trends, which also reduces the amount of storm a balance sheet could handle should we come into a more volatile economic environment.

So hopefully that provides a little color on what we’re seeing here across the S&P 500 and the valuations within. If you have any other questions, feel free to reach out. We’re always happy to answer them for you. Thank you very much.