Misconceptions on interest rates and higher equity values
There is a paradigmatic assumption that lower interest rates lead to an increase the value of equities, as well as of certain other asset classes. This is not false, but it is not necessarily quite true either. As the saying goes, it is complicated. Therefore, it is relevant to revisit the details of the assumption which tend to get overlooked, given the paradigmatic nature of the statement.
In modern finance, equity valuation is fundamentally based on discounted cash flow modelling (DCF). This involves modelling the money going into the company over time, the money coming out, and an estimate of the cost of capital for the company which leads to a discount rate. On this basis, the model then assigns a net present value (NPV) to the cash flows attributable to the equity holders, in other words the current financial value of the equity of the firm.
Lower interest rates lead to a lower WACC and discount rate which, other things being equal, lead to a higher NPV of equity (equity value).
What happens in detail, though, is that lower interest rates do not materially change the present value of the earnings or cash flows the company will generate over the coming 5 years. This change is only in the order of 1–3% depending on the company. The impact on the earnings generated between 5–10 years from now changes somewhat. But the real impact is that the earnings that are assumed to be generated in the time after the foreseeable future (say beginning 10 years from now) are cumulatively assumed to have become far more valuable. The change in the NPV of these cash flows will often exceed 25%.
In a typical model for an average mature company a 1% change in the interest rate leads to a ca. 15% change in equity value. Of the increase in equity value, some 0.3pp is attributable to the value of earnings generated within the next 5 years, and some 14pp to the value of earnings generated beginning a decade from now.[1]
There are two factors that then come into to play; the first is the assumed growth rate of earnings over time, which generally is explicitly considered in the model. The second parameter is the likelihood of future estimated earnings materializing as expected, which generally is not considered in the model. Standard DCF models have no parameters to adjust for any probability factors.
Should a fall in interest rates affect the probability of the future estimated earnings?
The practical question is how do we match a modelling conclusion that the net present value of earnings that are to be generated beginning a decade from now has become sharply higher, with an observed fact that the average lifespan of companies is becoming sharply shorter. Methodologies and conclusions somewhat vary, but one common observation of various studies is that the longevity of companies in the S&P500 has materially fallen, and is now well under 20 years[2].
The growth rate of the business clearly has a relationship to interest rates (a separate topic to consider). However, this is not the core factor, as the link between lower rates and higher equity values primarily works by assigning a higher present value to far-off events — events which have typically been estimated through a linear, deterministic and probably iterative formula. If a large proportion of the companies in the sample may be assumed to have vanished before those events take place, then this presents a fundamental problem.
Financial practitioners generally resort to the use of multiple-based valuation methods, due to their usefulness in relative valuation, in valuing groups and their applicability to time series (amongst other things). However, the multiple based valuations are either shorthand derivatives of DCF modelling or are directly based on comparable methods of assessing value. Multiple based valuation leaves implicit most of the assumptions that need to be made explicit or are at least noted in a full DCF model. Thus, the shortcomings and misunderstandings of DCF are only amplified, when even more of the details are overlooked.
Finally, it should be noted that the longevity of a company is driven by factors from the real economy while the discount rate in the DCF is a financial factor. Using financial tools to inaccurately model real-world occurrences over long time periods is fraught with error in the best of circumstances. Done carelessly, as most practitioners know, it becomes hazardous.
It is an observable fact that lower rates tend to lead to higher equity prices. Lower rates unquestionably lead to a change in the relative valuation of various asset classes and equities commonly are a beneficiary (lower rates lead to higher prices for fixed income assets). However, there are two very different propositions that should not be confused. One is that the object has become more valuable; the other that it is ok to pay more for it. It is the first, and the causal attribution of higher prices to higher values which is the problematic one, as this potentially leads to misunderstanding (or misrepresenting) the world in a manner which becomes unsustainable over time.
[1] These figures are indicative and representative, but verifiable against real world individual cases or sample sets.
[2] Corporate lifespans have recently been researched by McKinsey, Inosight and Credit Suisse, amongst others. Conclusions vary, as it is difficult to separate M&A, distressed M&A and corporate collapse from each other. Nevertheless, the overall conclusion and trend is uniform — corporate lifespans are becoming shorter.
