Aswath Damodaran on the AI capex boom

Aswath Damodaran on the AI capex boom

In a recent Substack post, NYU Stern School of Business Professor Aswath Damodaran – widely recognised as the ‘Dean of Valuation’ – delved into the current state of the equity market and the wave of artificial intelligence (AI) capital expenditures (capex).

As has been widely reported, despite 10-year U.S. Treasury yields surging 54 basis points in September 2026 to hit 5.29 per cent, stock markets have held firm.

The AI capex loop

To explain why markets are holding up, Damodaran argues the main force protecting equities from rising rates is a massive surge in corporate earnings driven by AI spending.

Damodaran notes that trillions of dollars are currently flowing into AI infrastructure and data centres, creating a double-sided economic cycle across corporates.

On one side, tech giants like Meta, Alphabet, Amazon, and Microsoft are spending heavily on AI architecture. In the short term, this capex depresses free cash flow and increases amortisation expenses on their income statements.

On the other side, hyperscalers’ capital spending directly becomes top-line revenue and net profit for chipmakers (Nvidia, TSMC), networking equipment vendors (Broadcom, Micron), energy/power providers (Constellation Energy), and specialised real estate developers (Equinix, Digital Realty).

Public company disclosures show corporate capital expenditures surged nearly 36 per cent year-over-year in Q2 2026 to US$503.7 billion. Consequently, aggregate net income for U.S. companies jumped 57 per cent in Q2 2026 versus Q2 2025 – rising from US$576 billion to US$904 billion – driven primarily by the technology, financial, and communication services sectors.

The cash flow disconnect (and balance sheet stress)

Damodaran, however, has urged investors to look beyond top-line earnings growth. Because companies are currently recycling earnings straight back into property, plant, and equipment (PP&E) for AI architecture, free cash flow isn’t keeping pace with reported net income.

We have reported on this in the past, sharing Apollo Global’s illustration of a slump in free cash flow for the Mag 7.

Figure 1.  Hyperscaler free cash flow slump

Source: Bloomberg, Macrobond, Apollo Chief Economist

Across the S&P 500, companies returned just 63 per cent of their earnings to shareholders via dividends and net share buybacks over the last twelve months – a low unseen since 2004.

Furthermore, book equity and debt across U.S. public firms increased by US$1.8 trillion and US$1.9 trillion respectively over the past year. In short, corporate balance sheets are becoming significantly more capital-intensive and debt-laden.

That’s a deterioration in quality at the same time that market breadth is slumping and so much of the S&P 500’s support relies on just a handful of companies at the apex of the AI theme.

Best and worst-case AI scenarios

Damodaran has outlined what happens if the actual business payoffs from AI diverge from current market expectations:

The stock market will re-price companies long before accountants write down failed assets. Waiting for formal accounting write-offs before selling underperforming AI businesses and bets means waiting far too long.

The AI trade: four options

Investors can’t sit out the AI debate; whether through active portfolios or passive index funds, everyone is exposed.

Damodaran offers four possible strategies:

1. Go all-in on AI disruption: Buy the disruptors and short the disrupted, betting on rapid transformation.
2. Follow market consensus: Accept current pricing, which assumes AI will create massive, enduring value. This is the path taken by most passive index investors (e.g., S&P 500 funds).
3. Be an AI sceptic: Steer new capital away from AI-heavy sectors and toward industries least vulnerable to disruption (such as food processing or leisure) or regions where adoption is slower due to regulation or labour costs (e.g., Europe or developing Asia).
4. Crash out (actively short / go to cash): Cash out of U.S. equities or short heavily hyped AI stocks. It’s worth remembering markets can remain irrational longer than short-sellers can remain solvent.

What Damodaran is doing

Damodaran says he’s taking a pragmatic approach designed to pass his ‘sleep test’:

First, he’s maintaining exposure through his long-term holdings in four AI-investing hyperscalers (Amazon, Alphabet, Meta, and Microsoft).

But, for the past year, he has directed almost all new capital into cash and short-term U.S. Treasuries yielding circa 4 per cent. While acknowledging he may be leaving upside on the table, the buffer provides peace of mind in a market priced for perfection.

A special note for younger investors: It’s worth considering the source of your future income. If your primary source of earnings is at risk of AI disruption, you are already significantly exposed to the AI trade. So, your financial portfolio should hedge against that risk by tilting away from AI-exposed assets.

The equity market’s resilience amid 5 per cent+ interest rates rests on an unprecedented surge in AI capital spending. While suppliers are reaping immediate windfall profits, hyperscalers are taking on high capital intensity and debt.

As we’ve noted here many times, during this AI boom and bubble, long-term investors need to balance exposure to the market, but with capital preservation uppermost in mind. Just as Damodaran is pumping inflows into cash, we have suggested diversifying into cash and even a little AA-rated private credit without exposure to property developments.

To discuss our private credit solutions, and whether they might be right for you, give our team a call on (02) 8046 500.

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MORE BY RogerINVEST WITH MONTGOMERY

Roger Montgomery is the Founder and Chairman of Montgomery Investment Management. Roger has over three decades of experience in funds management and related activities, including equities analysis, equity and derivatives strategy, trading and stockbroking. Prior to establishing Montgomery, Roger held positions at Ord Minnett Jardine Fleming, BT (Australia) Limited and Merrill Lynch.

He is also author of best-selling investment guide-book for the stock market, Value.able – how to value the best stocks and buy them for less than they are worth.

Roger appears regularly on television and radio, and in the press, including ABC radio and TV, The Australian and Ausbiz. View upcoming media appearances. 

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