Discounts and Discount Rates

Are equities cheap or expensive?

Photo: Joe Zlomak. Source: Morguefile

Earlier this year we discussed what goes into determining the fair value of a stock. It’s sum of all the future cash flows, discounted to present value.

The lower the discount rate used to calculate present value, the higher the present value. That’s why it’s called a discount rate. If the discount rate is 5%, then a dollar a year into the future is worth 95 cents today. If the discount rate is 2%, that same dollar is worth 98 cents. The same company with the same earning power can be worth more – can have a higher “fair” value – if interest rates are lower.

That’s the problem with historical comparisons. Compared with history, the stock market seems a little expensive.

50-year history of S&P 500 and its PE ratio. White-S&P(log scale); Green-PE; Yellow-Avg PE

Source: Bloomberg

Calculated on a trailing 4-quarter basis, the S&P 500 has a price-earnings ratio of about 18.8 right now. The 50-year average PE (covering bubbles, panics, inflation, and deflation) is 16.5. So its PE is about 15% above its long-term average. But interest rates are way below average.

10-year Constant Maturity Treasury. Source: Fed, Bloomberg

The average yield on 10-year US Treasury Notes has been 6.5%. Currently, they yield around 1.8%–70% below average. If you want to compare the market’s valuation to its historical average, you should also compare the inputs—and the discount rate is a major input—in your valuation model to their historical average. That’s why PEs were in the single digits for so long in the late ‘70s and early ‘80s. Interest rates were really high.

Now, I’m not going to get uber-bullish and say that the market is massively cheap. Adjusting PE ratios to current yields is tricky. Low yields now also reflect our slow-growth economy. But if the economy keeps growing, and rates stay low, and we don’t get into a shooting war or a trade war or have some other kind of crisis, the stock market looks like it’s fairly valued.

Douglas R. Tengdin, CFA

Chief Investment Officer

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