In recent weeks, I’m repeatedly hearing that current high equity valuations are justified by global low interest rates. Even Warren Buffet said the same thing.

What do the VP members think about it?

In recent weeks, I’m repeatedly hearing that current high equity valuations are justified by global low interest rates. Even Warren Buffet said the same thing.

What do the VP members think about it?

True. In an interview, Shankar Sharma made similar observations few days back saying that reducing interest rates reduce the discounting factor which improves NPV making even the bad growth look good.This has driven global markets from 2009 even with mediocre earnings growth, and in last 2-3 years, this phenomenon has shifted to Indian markets as well.

Interest rates are to asset prices what gravity is to mass. The lower interest rates are the higher asset prices go (or lower the gravity the slower will mass fall to the ground). This is what Buffett had said many years ago in a piece on inflation.

Risk free interest rates are set by the Central Bank (risk free because they can issue their own currency to meet their obligations). All subsequent ‘risk-on’ interest rates are added on top of this to the extent of perceived risk. If risk free rates move lower and close to zero or negative and are expected to remain so, then suppliers of credit or capital are tempted to take more risk for the same expected return or are willing to expect lower returns now from the same risk. This leads to all assets on a ‘risk continuum’ being priced up.

Looking at it another way, investing is laying money out now for getting more in the future. The minimum ‘more’ one should expect to get is what you will get for sure, i.e. the risk free rate. If the risk free rate is say 5%, the minimum you expect from any asset is atleast 5% every year. So for an asset that is expected to have a certain value in the future, the maximum price you will pay today is equivalent of future value reduced by, at the very least, 5% annualized (paying more doesn’t make sense because you are better off investing in a risk free asset). Now if the 5% becomes 4%, then for the same expected value of the asset, the maximum price you will pay will go up. In other words any asset that has a higher expected value tomorrow will get priced more today, as rates come down.

Now as rates come down lower and lower, asset prices will continue to climb up, with the effect that as Buffett has said, if rates come down to 0%, then a business with a stream of earnings forever, should get priced at infinity! Closer home, if I get a rate of only 5% from say a 5 year term deposit, I will be OK with lower returns from equity, say 8-10%. So the same stream of earnings of a business, which was priced to earn returns of say 12-14% will move up to earn just 8-10%.

In conclusion, as interest rates move down, in an inflationary environment (which makes us expect higher value from assets), asset prices,including stock prices, will go up.

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Theoretically yes, lower interest rates or expectations of lower rates over a period can justify higher valuations.

However practically this has been my experience so far -

This is generally used as the last resort to justify valuations that cannot otherwise be justified. It’s more like “There is no earnings growth, there is no corporate capex happening because utilization levels do not mandate this, there seems to be no obvious tangible reasons for why the market levels are this high other than simple demand and supply. Yeah, maybe it is due to interest rates being low”. To say it outright this is used as an excuse by noise makers (read analysts and TV channels) to suck in retail folks into a market they’ve patiently sat out of for whatever reasons

Unless one knows the basics of how a DCF works AND can do a basic model for this in excel one should not get fooled by this. Though someone like Buffett might go around saying he has never done a DCF, he has enough of other heuristics he can tap into to figure out at what price range asset levels start to become risky. Unless one can articulate at a discount rate of X%, EBITDA margins of Y% and an OCF/FCF trajectory of ABC this level of stock price appears to be justified (this being backed by some extent of logical financial modelling) falling for the low interest rate narrative is a step closer to disappointment over the short to medium run.

In short the very fact that this is being used to justify higher asset prices means the risk is considerable. Unless you have a clear cut plan to quantify and manage this risk, take any such report with a pinch of healthy skepticism.

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Low REAL interest rates justify higher valuations. Real interest rate is nominal interest rate minus inflation rate. If inflation is falling faster than nominal interest rates then real interest rates will rise and will not lead to higher valuations in the long term. As @zygo23554 suggested, expectations surrounding future interest rates are just as important in determining valuations as current interest rates. Moreover, valuations can swing widely if actual movement in interest rates turns out to be significantly different from expectations. No wonder Fed watching is a popular sport on Wall Street.

Real interest rate is what borrowers pay and lenders earn. For investors to build (or bid for) assets, expected real return on assets have to be higher than real interest rates.

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