The pain of discounting cashflows
Based on a simple Discounted Cash Flow model stock market valuation should be 25% lower
Equities are the asset class that offers investors the most challenging task of determining in which way they are heading. Recent market developments are no exception. Even as interest rates have risen to their highest levels in years, there hasn't been a genuine decline in stock prices yet. You can crunch valuation numbers all you want, but stock investors collectively look the other way. Let me elaborate.
Discounted Cash Flow
Call me old school, but I like to believe that traditional valuation metrics like a 'discounted cash flow model,' where a company's future cash flows are discounted to their net present value at a certain interest rate, provide crucial information about whether something is a sound investment or not.
This holds for equity market investments in general. So, I've been tinkering with this concept over the past few weeks. To keep it simple, I'll assume that the entire S&P 500 Index, which comprises the 500 largest listed US businesses, functions as a single company. This company generates a free cash flow of USD 100 this year in this hypothetical scenario. To clarify, free cash flows offer deeper insight into a company's health as taxes, stock options, or other, one-time, factors don't distort them. If you're diving into companies' earnings reports, focus on free cash flows.
Next, I assume that this 'S&P 500' company will perform quite well over the coming years, translating to an annual increase in free cash flows of 10%. My time horizon is 20 years. In 20 years, this company would have an annual revenue of USD 612.
Since a company theoretically exists indefinitely, we must add a terminal value to complete a discounted cash flow model. Typically, this value is estimated at somewhere between 10 to 20 times the final cash flow. In this case, that would be the USD 612 in year 20. For my example, I'll use a ratio of 15, resulting in an estimated terminal value of USD 9,174.
Weighted Cost of Capital (WACC)
Forget those numbers; the crucial factor is, of course, the interest rate at which I'm discounting them. The appropriate rate for discounting cash flows is the 'weighted cost of capital,' simply the weighted average of the costs of equity and debt. Let's say the S&P 500's capital structure is 50% equity and 50% debt, and the weighted cost of capital was 8% before the massive interest rate hike starting in 2021. By the way, 8% is a quite reasonable assumption for a typical healthy company.
Over the past two-plus years, the average US interest rate has increased by four percentage points. This implies that the weighted cost of capital has risen by two percentage points (since the S&P 500 in this example has 50% interest-bearing debt times the four percentage points increase) to 10%.
When you perform a net present value calculation for the cash flows and terminal value over the next 20 years, using discount rates of 8% and 10%, you find that in the latter case, the S&P 500 company is worth 24%, nearly a quarter, less than in the scenario of an 8% discount rate.
Of course, no two companies are valued the same way, making this analysis purely hypothetical. However, it would not be out of place when considering the S&P 500 Index as a whole. Moreover, a valuation decline of 24% clearly demonstrates the extremely negative impact of rising interest rates.
As outlined above, stocks are driven by more factors than just valuation. In fact, in the short term, it's almost always macroeconomic or sentiment indicators that determine the market's direction. But bear in mind that when sentiment shifts, most investors suddenly latch onto valuation as a reason the market should decline. Market valuation doesn't matter until it does!