Myth-breaking: Low rates do not support high valuation


One of the strangest transactions I have worked on as an investment banker at Citigroup was the initial public offering (IPO) of a Kuwaiti property company. This was during the real estate boom of the 200’s when almost every Middle Eastern country was competing to build the tallest skyscrapers. Often, money was needed from the IPO to start construction. The land plot was originally a patch of desert near the city of Kuwait. It requires a rather vivid imagination to realize its potential.

My job as an M&A analyst was to create a Discounted Cash Flow (DCF) model to evaluate the company. Real estate development takes time, the money from the IPO was supposed to be invested in real estate stocks. These were forecast to grow 15% annually. This was the main idea of ​​the model that influenced the assessment. As an analyst, you don’t get paid to ask critical questions, but it seemed like a weird business model.

IPO never happened. The global real estate market collapsed shortly after that, which was hardly surprising given such projects. But I have learned how sensitive the DCF models are to the original estimate, which is usually the rate of growth for revenue and expenditure forecasts and the cost of capital going back to the present to leave future cash flows.

Interest rates have a big impact on the valuation of such companies and the lower the discount rate, the higher the valuation. As interest rates around the world continue to fall and reach all-time lows, we should expect a new system with record-high equity quality for stocks across the market.

Of course, money relationships are rarely linear and we have a good set of data to evaluate this theory.

Book jacket in the history of financial markets: a reflection of the past for investors

Interest rates and P / E multipliers in the US stock market

According to Robert J. Schiller, interest rates have narrowed from 3% to 5% between 1900 and 1970. It was a turbulent time surrounded by the Great Depression and the two world wars. When inflation soared in the 1970s, interest rates rose 15% before they began their long landing, almost zero today.

In contrast, the equity multiplier, measured by the Cyclically-Adjusted Price-Income (CAPE) multiple, showed many smaller cycles of peaks and holes. The chart below indicates that when interest rates peaked at 1 interest0, the equity factor was very low. This may provide some visual support to the theory that increasing bond yields lowers a company’s valuation.

Interest rate and P / E ratio in the US stock market

Chart showing interest rate and P / E ratio in US stock market
Source: Robert J. Schiller Library, Factor Research

Yet frequent chart i-bowling often leads the mind to the wrong decision. Not as good at pattern recognition as we believe. What if we calculated the average price-to-earnings ratio of U.S. stocks for the period 1871 to 2020 and divided them into quarters based on 10 years of U.S. Treasury yields?

The average P / E ratio was 15.8x and there was a slight difference in equity quality between high and low interest rates. There was certainly no linear relationship between low yield and high P / E ratio.

By interest rates and the P / E ratio quartiles in the US stock market, 1872–2020

Chartile showing interest rate and P / E ratio in the US stock market, 1872–2020
Source: Robert J. Schiller Library, Factor Research

Worldwide interest rates and equity multipliers

Although there is little evidence of a correlation between the two metrics, the 150-year observation period is quite long. In addition to the two world wars and the Great Depression, there were the Cold War, the value of gold, and all kinds of financial and economic crises. Perhaps it bears little resemblance to today. The present is an era of comparative peace, a global connected economy and a highly efficient capital market that is carefully managed by central bankers.

Here Japan can give some insight. From a financial point of view, it has made a major start in the rest of the world, in an environment of low interest rates since about 2000. Maybe it could provide a more timely view. Japan felt the stock and real estate bubble that spread in the early 1990s. The effects – exceptionally high P / E ratio – lasted until the end of the century.

But Japanese capital markets have seen a decline in bond yields as well as a decline in equity quality. The interest rate has been zero since 201 Interest and the P / E ratio is nothing but extreme.

Interest rate and P / E ratio in the Japanese stock market

The chart shows the interest rate and P / E ratio in the Japanese stock market
Source: Factor Research

Looking at the European and German stock markets, the average P / E ratio of the DAX index rose to around 2000 due to an increase in technology stocks, but then traded heavily between 10x and 20x.

At the same time, German 10-year bond yields have fallen from 6% to about -1%. As with data from the United States and Japan, there seems to be no relationship between interest rates and equity quality.

Interest rate and P / E ratio in the German stock market

List of interest rates and P / E ratios in the German stock market
Source: Factor Research

More thoughts

Although low discount rate application in DCF enhances valuation, it assumes that cash flow remains unchanged. Naturally, this is a flawed estimate and explains why there is no strong negative relationship between interest rates and equity quality.

Low interest rates are a sign of low economic growth, which means a less attractive outlook for the economy and its components. The advantage of cash flow discount with lower capital value is the expected cash flow reduction.

However, the P / E ratio has increased across the stock market since 2018. Doesn’t that indicate that low rates support high valuations?

Financial Analyst Journal Current Issue Tile

The short answer is ‘no’. It is not statistically meaningful and can only be explained by the spirit of the animal. Tesla is a prime example of Elon Musk. The company’s market capitalization is larger than most of its peers, yet makes a fraction like many cars. Such surges eventually evaporate and the assessment means return.

Yet lower interest rates may actually be higher equity multipliers, but only outside a certain point. When the rate drops to 0% or below, the bond does not serve any purpose of asset allocation, and so investors must reconsider traditional theoretical allocation models.

All capital invested for a fixed income needs to be re-allocated and there is plenty of room for re-determination of equity and other asset classes. This is reflected in the high valuation of start-ups and strong asset flows into private equity. Heck, it may be time to dust off plans for an IPO of a Kuwaiti real estate company.

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All posts are the author’s opinion. As such, they should not be construed as investment advice, or the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.

Image Credit: Getty Images / Winry

Nicholas Robben

Nicholas Robben is managing director of Factor Research, which provides quantitative solutions for factor investing. Previously he founded Jacada Capital, a quantitative investment manager that focused on equity market neutral strategies. Previously, Rabener focused on real estate across the property class at GIC (Singapore Investment Corporation Government). He started working for Citigroup at Investment Banks in London and New York. Rabner holds an MS in Management from the HHL Leipzig Graduate School of Management, is a CAIA charter holder, and enjoys endurance sports (100km ultramarathon, Mont Blanc, Mount Kilimanjaro).

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