It's often said that investors overreact to market conditions. When times are good and the bull is in control, investing seems easy. Everyone is getting richer, more and more people pile into the market, and prices can be pushed well beyond reasonable levels.

On the other hand, no price seems too low during a nasty bear market. Stung by month after month of losses, investors have a hard time getting past reasons not to put money in stocks. More and more people pile out of the market, and prices can be pushed well below reasonable levels.

While that may be oversimplified, there's firm evidence that it's true. One need look no further than the fascinating book Extraordinary Popular Delusions and the Madness of Crowds to see, well... extraordinary examples of "investors" gone wild. This Charles MacKay classic, first published in 1841, should convince anyone that sometimes a herd mentality can overcome even normally sensible people, causing them to act irrationally.

Most would agree that the markets reached irrationally high levels in the latter stages of what turned out to be the greatest bull market in history. That bubble popped in early to mid-2000, and now we're in one of the worst and longest bear markets in history. The natural question to ask, then, is if prices have now reached irrationally low levels.

One way to tackle this issue is to compare valuations over a long period of time. The following table shows the relationship of the S&P 500's price-to-free cash flow ratio (P/FCF) to its trailing five-year earnings growth rate:

    S&P 500 P/FCF-Growth Ratio27-year avg.        1.83Current             1.53High (1993)         2.69Low (1985)          0.97All data from Barra, as of Jan. 31 each year

Essentially, the table illustrates the premium that investors have been willing to pay for growth. I used P/FCF instead of P/E for reasons I've outlined before (namely, the "earnings" part of the P/E ratio is not as representative of a company's earnings power as free cash flow). Therefore, the P/FCF-growth ratio is similar to the more familiar PEG, but uses free cash flow instead of earnings.

The ratios above tell us that since 1977, investors have assigned S&P 500 stocks a P/FCF multiple that was, on average, 1.83 times larger than their growth rate. Currently, the multiple is only about 1.5 times larger. For comparison, investors paid the highest premium for growth in 1993 and the lowest in 1985.

Let's try another table, this time including stocks from the S&P 500/Barra Growth Index:

    27-year P/FCF-G averagesS&P 500                1.83S&P 500 Growth         1.84HighsS&P 500 (1993)         2.69S&P 500 Growth (2000)  2.77LowsS&P 500 (1985)         0.97S&P 500 Growth (1985)  1.00Current P/FCF-G ratiosS&P 500                1.53S&P 500 Growth         1.29                 % below avg.   % from lowS&P 500               16%            37%S&P 500 Growth        30%            22%

While their 27-year average is nearly identical to that of the S&P 500, growth stocks are currently farther below their average than the overall index, and much closer to their all-time low.

What are we to conclude from this? First, let's realize the limitations of these data. I'd much rather deal with forward than trailing growth rates. After all, what matters most in investing is the future. Trailing is all we have, but at least it gives us a reasonable idea of the swings of the market.

That said, the tables do give us a rather telling data point. While we certainly can't conclude that stocks have reached irrationally low levels, it's clear that valuations are somewhat below average in a historical sense for the S&P 500, and quite a bit below average for growth stocks.

Although the downside risk is much less than it was a few years ago, pessimism can obviously go higher and valuations lower. I'm definitely not calling a bottom here. If growth stocks were to touch an all-time low, for example, they'd still have another 22% to fall.

However, growth stocks haven't been valued this low since 1985. If you have a long-term outlook (five years, preferably longer), your downside risk in this particular group is as low as it's been in a long time.

Let's try one more table, this time comparing some individual stocks:

      Stock                           P/FCF   Growth   P/FCF-G
    Microsoft  (NASDAQ:MSFT)        16.69    16.54     1.01Cisco  (NASDAQ:CSCO)            32.97    24.00     1.37eBay  (NASDAQ:EBAY)             64.85    82.62     0.79Dell  (NASDAQ:DELL)             33.57    20.20     1.66Pepsi  (NYSE:PEP)               21.42    14.28     1.50Constellation Brands (NYSE:STZ) 14.11    21.60     0.65
All data from Multex

When looking at individual stocks, you'll obviously see a lot of variance. By this method, there are some attractive values out there, and some not so attractive.

While these numbers, once again, use the trailing five-year growth rate, sites such as MultexInvestor provide forward estimates. Sometimes, there's little difference: Multex lists the long-term growth rate for Microsoft at 13.43, for example. But eBay's long-term estimate is 41.00, which would just about double its ratio.

There are no one-stop metrics out there, and the P/FCF-G ratio is no exception. But it does provide an interesting perspective, and it shows investors are just not paying as much for growth as they historically do. Unless "things are different this time," these valuations will eventually return to normal levels.

Rex Moore will write for food... preferably donuts. At press time, he owned shares of Microsoft, eBay, and Constellation Brands. You can see all his holdings on his profile page, or drop him an email here. The Motley Fool is investors writing for investors.