Relationship between valuations, growth prospect, and cost of capital
Each company is created to provide products/services/solutions to each individual consumer to earn a profit from those offerings. In other words, a company is created to absorb capital from consumers and then distribute earned capital to those within the ecosystem. In simple words, a company is created to manage cash flow provided by the central bank. With this understanding, the value (price) of a company is equal to the sum of its discounted future cash flows. The formula of valuation is Price = Earnings/ (r-g), where r is the cost of capital (risk premium on top of risk-free rate) and g is the expected growth rate of earnings.
Surely, in discounting the earnings, r and g are the expected growth in earnings and cost of capital over the future period when these earnings are accrued. That is, it is theoretically not, say, the cost of capital next year alone but the long-term expected cost of capital.
The table above shows the fair price (price to earnings) of a company, that is, how much one should pay for each dollar of earnings. As you may see, different combinations of cost of capital and growth rate resulted in different fair prices, where it makes sense to say that that is why absolute PE multiples are not a good indicator to make the right investing decisions.
A stock with a 5 PE ratio didn’t mean that this is cheap and undervalued, and the same logic goes for a stock with a 100 PE ratio. This is something to do with r and g. Let us further explain this logic with the concept below.
For example, one should pay 9 times multiple for each dollar of earnings for Company ABC with a cost of capital of 13% and growth rate of 2. At this same discount rate, Company DEF with higher growth of 8% would be fairly valued at 20 times earnings while Company XYZ, anticipated to grow at 10%, should trade at a far higher PE of 33 times. Shortly to say, the higher the expected growth of future earnings, the higher the stock’s fair PE valuation, all else being equal.
Any change in the discount rate (cost of capital) will do affect valuation. For instance, if the cost of capital falls by 3% to 10% (say, due to a lower interest rate), the fair PE for Company ABC will rise to 13 times from 9 times while that for Company XYZ will expand by much more, to infinity (in theory) from 33 times. What it means is that if a company can grow its earnings consistently over the longer run, at a clip faster than its cost of capital, the sky is the limit. This explains why we occasionally see very rational investors paying four-digit valuations for a company now. For instance, Tesla. But we also know the law of diminishing returns dictates that there does not exist such an eventuality.
The above partly explains why market valuations have been rising steadily — — in lockstep with central banks’ progressive cutting of interest rates. Stock valuations are near the highest in history because interest rates are at record lows! It is not irrational, it is mathematics.
Additionally, in a very low-interest-rate environment — — — such as now — — — high-growth stocks command significantly higher valuations, relative to low-growth stocks. A case in point: At a 13% discount rate, the fair PE for Company XYZ is four times that of Company ABC (33/9) but at a higher 14% discount rate, it is only three times (25/8). This explains why growth stocks have been favored over value stocks and why, as a group, they have outperformed in recent years.
Conversely, when the market expects interest rate hikes, high-growth stocks often suffer much sharper price falls, because the bulk of their earnings is in the future, which will be worth far less today at higher discount rates. Hence, it explains why Tesla falls from $1200 to $850 during Federal Reserve are sending a strong signal that they prepare to hike the interest rate in March 2022. As value investors, we should continue to see the market would be volatile and in a downward correction to reflect the latest cost of capital. However, let's not forget, we also should focus on the expected growth rate of ratings, where the increase of expected growth rate of earnings would mitigate the hike of interest rate in the longer term. For example, despite Apple dropping from $183 in December 2021 to $162 on 24th January 2022, the stock price was quickly recovered back to $170 with the expected long-term growth rate. On 27th January, Apple earnings beat the calm market on top and bottom line by nice margins. iPhone sales showed solid growth over the period amid supply chain disruption. Free Cash flow continued to see tremendous improvement.
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