Shares of stock represent very small ownership stakes in businesses. How do we arrive at a fair value of what any business is worth? You take all future estimated cash flows from the business, and discount them back a certain rate to a present value. How do we estimate all future cash flows from a business, and what discount rate do we use?
That’s where valuation gets tricky. If the business outlook is dicey and you are uncertain of the future cash flows, you’d discount them at a higher rate. If the business outlook is stable and low risk, you would discount the cash flows at a lower rate. We call this the risk premium.
Imagine it is January 1st, 2022 and you can invest in an asset that is projected to pay you $1,000 ten years from now. You are trying to come up with a discount rate to arrive at fair present value to pay for this asset, so you check to see what a 10 Year US Treasury Bond rate is paying at the moment. You check and you see it is at 1.63%. You then decide that the counterparty in your investment is riskier than the US Government, and not nearly as certain to pay you back as the US Government would be. For this reason, you tack on 4.00% to the US Bond rate and arrive at a total discount rate of 5.63%.
This discount rate can also be considered your “required rate of return“. In order to hit your required rate of return goal of 5.63% annualized, you will only pay $578.27 today for this investment. You are happy to pay this price because you will be able to hit your required rate of return.
1 day later you hear the 10 Year Treasury rate has jumped to 4.00%. You think you would rather have the certainty of the US Treasury investment at a lower interest rate than the uncertainty your current investment. Unfortunately, the only buyers you can find are using the same valuation framework you originally used, and they add a 4% risk premium on top of the current 4.00% Treasury rate. This increases your original discount rate of 5.63% to 8.00%, and that brings down the present value of your investment from the $578.27 you paid to $463.19 for a total decline of 19.90%. Ouch!
You’re heartbroken that in order to sell you have to take nearly a 20% hit, so instead of selling you decide to invest more in a similar investment because now the expected returns are higher!
What Drives Discount Rates
Discount rates have seemingly spiked this year, there is a chain of events as to why that has happened which we won’t go over in detail here but the change in Treasury Rates has been quite a sight. If we assume everything is priced at a premium rate to Treasuries, you begin to see why valuations have come unglued this year.
All risk assets should be priced at a premium discount rate to riskless US Government securities, to account for the risk factor. (Source for picture below: Charlie Bilello)
Company earnings have increased, yet the valuation people are willing to pay for stocks has fallen over 28% (Source: JP Morgan):
There are thousands of variables that are accounted for across the world every single day that drive the risk appetite of the collective market participants. To name a few:
- Global turmoil
- Economic Strength/Weakness
- Central Bank Policies
- Political Stability
Historically, the stock market has done a pretty good job of rewarding investors for the risk involved. The CRSP 1-10 US Market Index returned 9.93% annualized from 01/01/1926 – 08/31/2022 compared to 3.24% for riskless One-Month US Treasury Bills. This resulted in over 430 times the wealth creation that one would have received in Treasury Bills:
Of course, it wasn’t for the faint of heart. Further, not all equities have the same discount rates. Buying large groups of stocks with high discount rates (value) historically has shown to provide a premium over those with low discount rates (growth).
For more fun on valuing a business, check out this Warren Buffett clip:
Another great source on business valuations and the implied equity risk premium would be the check out the website of NYU Valuation professor, Aswath Damodaran, who updates the implied equity risk premium every month on his site: Damodaran Online: Home Page for Aswath Damodaran (nyu.edu)
Disclosures: This article is for informational purposes only and should not be considered a recommendation. Information contained in this article is obtained from third party resources that Meredith Wealth Planning deems to be reliable. Past performance does not guarantee future results. An investor cannot invest directly into an index. The CRSP 1-10 index and Fama French Growth/Value Indexes are unmanaged indexes that do not account for trading costs and expenses.