What You Need To Know About Low Rates & High Stock Prices
Do low rates lead to higher stock prices?
Or is this a case of correlation ≠ causation?
A common argument used to explain the link between low rates and roaring equities is that low interest rates mean higher present values, and therefore higher equity values.
What does this mean, and more importantly, is it valid?
What proponents of this argument are referring to is the Discounted Cash Flow (DCF) method.
DCF is a method of creating a model of a company’s financial standing by first forecasting its financial performance and cash flows up to some point in the future.
For example, an analyst could forecast up to 10 years worth of future cash flows to get some idea of how the company’s financial statements could look like in a decade’s time based on what is forecast.
This is the “CF” part.
After this is done, a terminal value needs to be determined.
Terminal value being a suitably dramatic name for the business’s cash flows beyond the previously forecasted time period (10 years in the above example). It assumes that a business will continue to generate cash flows at a fixed growth rate in perpetuity.
It is important to note that the terminal value makes up the bulk of the forecasted cash flows’ present value, simply because it stretches into perpetuity. This in turn makes the final equity value very sensitive to changes in interest rates.
Which is when the “D” part comes in.
In order to get an estimate of the company’s equity value today, the sum of future projected cashflows has to be discounted to the present.
As such, interest rates* matter in DCF models because of the “D” part. The lower interest rates are, the less future cash flows and the terminal value will be discounted by.
This necessarily means a higher present value, and hence a higher forecasted total equity value and share price. Which is what folks are referring to when they say that lower interest rates lead to higher equity prices.
It is important to note that this argument is based on a very broad assumption: that a lot of market participants, at least enough to heavily influence prices, are making the decision to buy stocks based on DCF models.
However, this just isn’t true, not least because of the limitations inherent in DCF modeling.
Firstly, based on our brief overview of how DCF models are constructed, it should be clear just how subjective the whole process is.
Every analyst will have different forecasts for future cash flows, growth rates, and terminal values. Hence, each DCF model will project different equity values for the same company.
Moreover, the DCF makes some big assumptions, not least of which are those used in the terminal value calculation.
How realistic is it to assume that a business’s cash flows will grow at a fixed growth rate forever?
Because of these factors, the final equity price that DCF models forecast really is good only for “reference”.
Given how quickly financial conditions, narratives, and the global economic environment can change, most market participants do not have the luxury of relying too heavily on DCF model forecasts.
That is, however, not to say that DCF models are useless. Their true value lies in the thought process that analysts have to go through while working out their forecasts.
This rigor helps them really understand the company’s business model from a micro level, but not a macro, systems wide view of interdependent variables that together affect the company’s stock price.
Ultimately, the people who buy into the low rates = high equities narrative fall into the trap of reductive thinking, attributing outcomes to a simple, single cause.
As a result, they neglect to consider the overall complexity of markets, as well as the power of human emotion and herd behavior.
*If you are interested in learning more on how interest rates affect the discounting process in DCF models, look up “Weighted Average Cost of Capital (WACC)”
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