Key Points
- A Kuwaiti property company’s IPO in the 2007 real estate boom highlights the sensitivity of DCF models to key assumptions.
- Interest rates significantly influence company valuations, with lower rates leading to higher valuations.
- Contrary to expectations, there is no linear relationship between low yields and high P/E ratios.
- The 150-year observation period shows little correlation between interest rates and equity multiples across the world.
One of the more peculiar transactions during the 2007 real estate boom was the initial public offering (IPO) of a Kuwaiti property company that required vivid imagination to grasp its potential. This experience highlighted the sensitivity of discounted cash flow (DCF) models to key assumptions, especially the growth rates for forecasting revenues and expenses, as well as the cost of capital for discounting future cash flows to the present.
Interest rates play a significant role in company valuations, with the lower the discount rate, the higher the valuation. Given the declining interest rates globally, a new regime with record-high equity multiples for stocks across markets is to be expected.
Interest Rates and P/E Multiples in the US Stock Market
While it may seem that rising bond yields lead to lower company valuations, the historical data from the US stock market paints a different picture. The average price-to-earnings ratios of US stocks for the period from 1871 to 2020 showed minor differences in equity multiples between periods of high and low-interest rates. This indicates the absence of a linear relationship between low yields and high P/E ratios.
Interest Rates and Equity Multiples across the World
Looking beyond the US, a 150-year observation period across the world shows little evidence of correlation between interest rates and equity multiples. The data encompassed turbulent historical periods, including the Great Depression, two world wars, the Cold War, the gold standard, and various financial and economic crises. The observation period may not be directly comparable to the current era, characterized by a globally connected economy and highly efficient capital markets that are carefully managed by central bankers.
Further Thoughts
It should be noted that applying a lower discount rate in a DCF raises the valuation assuming that cash flows are unchanged. However, lower interest rates tend to be symptomatic of lower economic growth, which implies a less attractive economic outlook. While lower interest rates could lead to higher equity multiples, it may only hold true beyond a certain point, signaling a need for investors to rethink traditional allocation models.
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All posts are the opinion of the author and should not be construed as investment advice. The opinions expressed do not necessarily reflect the views of CFA Institute or the author’s employer. Image credit: Getty Images / wonry
