Rethinking Stock Valuation Multiples in time of Lower Interest Rates
12 Dec 2020 | Eugene Ng | Founder & CIO | Vision Capital
With interest rates been declining over the last 30–40 years and at all time lows, recent question by Puru Saxena (@saxena_puru) and reply by Robert Ditrych (@rditrych) sparked further thinking and for me to pen down some of my thoughts.
The following charts might make us re-think differently. That with low interest rates, we ought to be demanding higher stock valuation multiples (and vice versa). Perhaps higher equity valuation multiples (e.g. Price-to-Sales (P/S) and Price-to-earnings (P/E) ratios) would now have to be the new norm at least for now while rates are still very low.
Interest rates have been declining over the last 40 years. Real bond yields in the US are now negative.
Financial media tells us rising valuation multiples are a concern for rising stock market valuations, citing rising PS and PE multiples.
But looking at longer-term 70 year charts tell us otherwise…
Interest Rates rising and falling with Earnings Yield (1/PE)
📉Lower Interest Rates ➡️ 📉 Lower Earnings Yield ➡️ 📈Higher PE Ratios
📈 Higher Interest Rates ➡️ 📈 Higher Earnings Yield ➡️ 📉 Lower PE Ratios
Lower risk-free interest rates, lower earnings yield (1/PE) which implies higher PE equity valuation multiples.
Lower corporate bond yields, lower earnings yield (1/PE), higher PE equity valuation multiples.
One way to think about it, ceteris paribus (revenue, profits, cash flow growth rates, profit margins, etc). Lower interest rates, specifically via lower risk-free rates drives lower cost of equity, which also in turn drive down lower risk-free interest rate benchmarks. That lowers the cost of raising debt. With lower cost of equity and debt, results in a lower weighted average cost of capital (WACC).
If WACC or the interest rate to discount future cash flows is lower, the present value of the same future earnings /cash flows should be now worth more, all things equal. According, that should be reflected in higher discounted cash flow (DCF) equity valuations as to what investors think companies are worth versus their current values.
The buying could lead to higher stock prices and eventually be reflected in higher relative valuation multiples, and this case, Price-to-Sales (P/S) and Price-to-Earnings (P/E) ratios.
Admittedly, this is an extremely simplistic way of looking and thinking about this, and there are many more moving parts and considerations that I could be missing, but hopefully this provides a starting point to be thinking about this.
Perhaps given that interest rates are at all time lows, perhaps the stock market is not as overvalued as one should
To add on, if the company is growing profits even more rapidly (higher Net operating profit after tax NOPAT growth) , higher P/E multiples should be warranted.
And if the companies are even more profitable (higher ROIIC), higher P/E multiples should be also as well warranted.
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