Equities are the place to be – Capitalization Multiples overcome Emotional Fear
The current 30-year U. S. government bond rate of 2.65% is the impetus for this article. Why? The answer to this question is found in the language of finance: the numbers. Please refer to Security Analysis’s Chapters 35 thru 39 for a multiples background reference. The Molodovsky method is a proxy for the Graham and Dodd preferred method of valuing stocks. Put differently why are stocks so darn cheap? Why are market historians uniformly pounding the table to buy?
A company doubles in size when it grows in just over 7% a year for a decade. Thus, with low discount rates, stocks (long duration assets) are fundamentally worth more if they can sustain their growth rate. The confusion lies with many market followers, because they have not studied Molodovsky or the Rule of 72’s. Currently, interest rates have fallen very dramatically such that the starting point for calculating the discount factor for future earnings or dividends has halved from just over 5% to 2.65%. This large drop is rare, and its implications on valuations are huge. We must go back to the late Forties to see a similar situation. At that point, stock dividend yields were greater than bond yields and the 15% plus rate of return for the Fifties was to be had.
For today, the question becomes how much does the drop in the discount rate mean to stocks? Let’s look at the market as just one company or as Buffett would say let’s do a see through analysis. The company is the S&P 500 whose operating earnings doubles in approximately a decade (i.e. a 7% growth rate). If we then do a dividend discount model or an earnings growth rate model to calculate its value we have a framework to determine the importance of the decline in interest rates. Numerically, if you hold the terminal multiple constant* (a very conservative assumption) the change in discount rate changes the present value by over twenty percent. The earnings growth would have to slow approximately 30% to have no positive effect on valuation.
The conclusion is that the reduction in interest rate has a positive effect on valuation which more that compensates for slowing growth rates. Many have emotionally run to cash or government securities. The rational investor should be doing the opposite. An increase in equity weightings is numerically correct. In 1950, stocks yielded more than government bonds as they do today and stocks were the place to be. Stocks are the place to be today; the value investor will again be well rewarded.
