In the phrase "discounted cash flow" (DCF) the first word is “discount”, but most who work in equity valuation pay far more attention to the third word, “flow”. The discount part of DCF analysis gets scarcely any attention. Go ahead, take a look at twenty randomly selected sell side equity analyst reports, and count the number of times changes of the discount rate come up. I’ll wait.
In the Sept 26 issue of The Economist, Buttonwood[1] gives some much needed attention to this frequently neglected topic. Citing Bernstein[2], he points out that wealthy societies tend to experience reduced discount rates. The logic of this is straight out of sociology: Those who are well off are better able to defer gratification.
I’ll go further than the Buttonwood article. Wealthy societies correlate with longer lives and reduced probability of early death due to external sources of violence, such as invasion. A dollar tomorrow needs to be worth a lot more in a violent environment tomorrow for it to be worth it to not spend it today. You can take a piece of psychological advice and apply it: “Live each day as though you were going to die tomorrow” implies a very high discount rate, because under this (happy and energetically life-embracing) philosophy, tomorrow’s dollar is not nearly as important as today’s dollar.
How does that apply to the COVID-19 economy? Interest rates are very low, and despite the tumult and destructive economic environment, everyone is deferring a lot of gratification until next year, when they can start really living again. When you watch a lot of Netflix, refuel your car every other month, work at Zoom meetings all day or in your pajamas from your spare bedroom, you are probably deferring your engagement with things until the post-COVID economy.
If this scenario is right, then whenever the post-COVID economy does arrive, it could have robust economic growth combined with a sudden increase in the human-experience-grounded discount rate, with accompanying higher interest rates, higher inflation, and lower stock prices.
When I do DCF calculations I tend to use a single discount rate that varies slowly with time. I rarely change it, and when I do, I’m changing it only in response to these very broad, civilization-wide discount rates that are intended to represent the preference for dollars next year compared to this one. In those equations, a sudden shock downward (like a COVID shock), then causes sudden increases in equity values. So here we find some of the explanation for why stocks are hitting new highs despite poor GDP measures. Dollars are chasing 0.5% to 2% yields, so equities look much more valuable than they did two years ago.
The problem, as indicated, is that even though discount rates may be systematically lower than they were pre-COVID, the actual change might be a 0.5% change, and that’s it, while investors are treating it as a 2% to 3% decline. The temporary shock downward in the discount rate will be reversed later by a shock upward in the discount rate. When the market senses this, stocks could experience corrections equivalent in magnitude but opposite in sign to the gains they made in late summer and autumn of 2020.
1. Buttonwood. “Asset Prices and Growth”. The Economist, Sept 26, 2020. https://www.economist.com/finance-and-economics/2020/09/24/does-economic-growth-boost-stock-prices
2. William J. Bernstein. “The Paradox of Wealth”. Financial Analysts Journal, September/October 2013 Volume 69, Issue 5. https://doi.org/10.2469/faj.v69.n5.1. ISSN: 0015-198X. https://www.cfainstitute.org/en/research/financial-analysts-journal/2013/the-paradox-of-wealth
No comments:
Post a Comment