Nov

24

TaurusIt's good to remember that stocks are valued based on an infinite stream of cash flows. And any balance sheet losses on assets held just affect the book value temporarily and are lost in the fullness of the sweep of payments for risk and innovations and entrepreneurial ability . Same for whether earnings growth is going to be 1 % or 5% next year. The earnings yield versus bond yield is now at close to an all time high. The yield on risky loans has risen and the cost of debt capital has eased. Presumably if the default rate on subprimes is 10% , it is more than compensated by the increase in yield that such loans would now carry . All this comes to a head with the disruptive move at the close on Wed, down 1.5% in 30 minutes. This reminds one of the breaking in of horses featured in such novels as Monte Walsh where the unbroken horse gives a final leap into the corral fence before shuffling off with the owner paying the debt to Monte.

Phil McDonnell runs some numbers:

Recently the rate on 30 year Treasuries has fallen from about 5.3% to about 4.45%. This is a decline of about 17%. So if the long term earnings are discounted at the long term rate then a very simplistic back of the envelope calculation shows that the value of stocks should rise by something like 17%. However the reality is that stocks have fallen about 8% from when the rate was 5.3%. Together the 17% increase in value plus the 8% should combine for something like a 25% increase in stock values. Some might argue that a more sophisticated model would use the one year rate to discount expected one year out earnings and a two year rate for two year earnings and so on. That is true. But it is worth noting that all the shorter term rates have fallen even more percentage wise than the long term rate.

Bruno Ombreux extends:

Another exercise is to look at what happens when earnings are changing over time. In the discount formula, the denominator is a power. As a result, early years are heavily weighted and later years much less so.

Let's value the stream of discounting earnings as a perpetuity, because it is easy. It is earnings/interets rate. Let's use 8% which is reasonnable for a risky asset and in line with drift.

Assuming constant $10 earnings, the stock is worth 10/0.08 = 125.

Now let's assume that earnings are going to take a hit for the next 5 years.

If earnings are 0 for the next five years and then 10 in perpetuity, the company is now worth 125/(1.08)^5 = 85

This a a 85/125 = 32% drop in the value of the company.

The next few years are very important in valuing a company. It is not surprising that stocks drop on the slightest hint that they could experience troubled times ahead, even if in the long term they are profitable.

George Zachar cautions:

Notional interest rates are only one factor to consider in calculating the appropriate discount. In the current era of (relatively) low and stable rates, perhaps other variables play a increased role.

What tax rate will those future earnings bear? What is the forward trajectory of the regulatory ratchet? Are currency preferences an issue? Finally, should one use real or nominal rates to discount? That would imply the need to forecast inflation too.

While notional rates remain important, the growing/shifting burdens imposed by Washington, and the increased role of international capital pools, means yields are now one discounting factor among many.

Alston Mabry concurs:

To extend George's argument: What about projections for forex rates? Liquid capital flows across borders, and many investment equations now must contain a forex conversion factor. Must not non-domestic investors evaluate future cash flow discounted by both rates and currency fluctuations?

Gregory Van Kipnis raises an interesting point:

There has been always been a dichotomy in market valuation between the earnings discount model approach and the book value approach. If we reduce the current discussion to a P/BV versus a P=PV(E,g,i) model for assessing the market outlook, the following additional point may be important to consider. Is there a relationship between BV, on the one hand, and E and g, on the other? If BV (book value) losses were simply a drop in the net value of bricks and mortar there might not be much of a connection to future reductions in E (earnings) and g (growth in earnings). If on the other hand, much of the loss of BV is the destruction of income earning assets (mortgages and their related derivatives) then E and g are proportionately reduced as well. Since such a large proportion of the S&P earnings is related to the financial services industry the current 'neutron bombing' of the housing sector, and the associated loss of financial BVs, it is likely to translate into a more protracted bear market, I fear.


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