Following on from last week’s article on the Reverberations from Rising Yields, we take a look at what exactly a “discount rate” is and the influence it has on equity values.
A key input in valuing a security is the expected risk-free interest rate. This should be a rate that reflects expected inflation, time preferences and real growth of the economy.
An analogy that demonstrates discounting at its simplest might be:
- Imagine you expected to receive $10 in 2 years’ time from a local business, call it an IOU, and maybe even imagine you have a pretty piece of paper to prove it.
- But suddenly you needed the $10 to buy lunch.
- You asked a friend to give you some money for lunch, and in return they get the IOU.
- You understand that you can’t expect the full $10 for lunch today for your IOU – but what DISCOUNT to $10 should you expect?
- You expect to receive a discount because giving your friend an IOU isn’t like borrowing from your friend.
- If you borrowed from your friend they could come and 'ruff you up' for the money, however, if the local business goes bad, CAVEAT EMPTOR all the way to your local café.
If your friend is wise they may ask;
- What is this business you expect the $10 to come from?
- What security, if any, does the business have that might support the $10 you are now owed?
- What could change between now and then – are their prospects improving or deteriorating?
- What other options do I have instead of giving you the money for lunch today – could I put in the bank instead?
Based on these considerations, your friend may offer you $5, $8 or even $9.80.
All of the above considerations and complexities therefore fall away through the magic of price.
The discount “rate” in this case will be the amount of the difference between the price you receive for the IOU and the $10 you expect, and usually expressed in yearly amounts of interest
Clearly the IOU example stretches directly to the type of investment available in the sharemarket. Using this theory market participants typically value securities on what is referred to as a “discounted cash flow” basis. It answers the question “what are you willing to pay today for uncertain cash flows (dividends, growth) in the future.
Careful review of the questions your friend may have asked highlights one question that had NOTHING to do with the $10 IOU, and that was “where else could she invest her money?”.
She might give it to another friend, who is being paid $10 by a much more trustworthy business that she frequents.
Alternatively, she may have kept it safely locked away in the bank, which would pay her a nominal rate of interest.
Keeping her money in the bank likely represents the “safest” return she may receive. We would therefore expect this return to provides a “floor” as to the discount rate she charges you.
Your friend builds her discount rate based off this floor and subject to the answer to her other questions.
Likewise, in the share market, investors use the interest earned on “safe” 10-year government bonds or the “risk-free rate” as a floor for the discount rate they demand.
Market participants typically use the yield on government bonds as a proxy for the risk-free rate as these securities are typically considered “safe” as the risk of a government defaulting is generally considered very low (putting Argentina and Venezuela aside … ).
Investors add to the risk free rate an amount for a premium associated with the risk of uncertain cash flows in the future.
In today’s environment, the interest rates earned from both your friend’s savings account and 10-year government bonds have become rather paltry, returning no better than 1%.
With this, the “floor” for the discount rate has reached a level that is very low.
As a result of the floor being lowered, the amount market participants have been willing to pay for investments has increased.
This has purely been a function of the paltry returns available from alternative uses for their money.
That is, it has had LITTLE to do with changes in the expected magnitude or uncertainty of cash flow from the investments or, drawing back to our example, of the local business for which they hold “IOUs”.
The share price of Transurban - a company with relatively stable, predictable cash flows, best demonstrates how changes in the discount rate can change the amount investors are willing to pay for an investment.
Changes in its share price has largely been a function of changes in the risk-free rate “floor”:
Source: First Samuel, IRESS
Duration and rates
Back to our example (and ignoring compound interest), if we expected to be paid $10 in two years and we:
- Discounted this amount by 20% per year, we would be willing to pay $6 today.
- Discounted this amount by 10% per year, we would be willing to pay more: an amount of $8 today.
The change in the amount we were willing to pay with a change in discount rate is therefore $2.
Compare this to if we expected to be paid $10 in total over two years, but receive $5 per year. If we:
- Discounted this by the same rate (20% per year) we would be willing to pay $7 today.
- Discount this amount by 10%, we would be willing to pay more: an amount of $8.50.
The change in the amount we were willing to pay with a change in discount rate was $1.50.
Although we are ultimately being paid the same amount ($10) we can see that there is a difference in the change of the amount we are willing to pay when our discount rate changes.
The difference in the amount we are willing to pay was greater when all of the cash received at the end of the two-year period, as opposed to split over two years.
This illustrates how purely a change in the “discount rate” can push up valuations.
It also illustrates the concept of “duration” which in effect is the sensitivity the price of an investment has to a change in interest rates.
The concept of “duration” also translates to companies.
Companies whose cash flows are largely weighted towards the future (broadly “growth” stocks), have benefited more than those whose cash flows are largely weighted towards the near term (broadly “value” stocks).
We have seen this recently:
Source: MST Marquee, IRESS, First Samuel
Where to now?
These rate driven price changes have pushed valuations to historically high levels.
The questions being asked by market participants are: what is the outlook for the risk free rate (or the floor) in the future? Will rates revert to their historically higher levels (and if so when) or continue to decline?
As highlighted last week we have seen some signs of rate reversion since September, which has benefited some your companies, which are typically more “value” focused.
In addition, we have chosen to steer clear of investing in companies that have been a pure “bet” on the direction of rates, such as Transurban and a majority of real estate investment trusts (REITs).
In constructing your portfolio, the degree to which your portfolio is exposed to changes in rates is a key consideration and a topic we will touch on in the coming months.