introduction
One of the more odd transactions I worked on as an investment banker at Citigroup was the IPO of a Kuwaiti real estate company. This occurred throughout the 2007 real estate boom, when almost every country within the Middle East was vying to construct the tallest skyscrapers. As is commonly the case, the cash from the IPO was needed to begin construction. The site was essentially a bit of desert near Kuwait City. It required a reasonably vivid imagination to understand its potential.
My job as an M&A analyst was to create a reduced money flow (DCF) model to value the corporate. Since real estate development takes time, the proceeds from the IPO were to be invested in real estate stocks within the meantime, which were expected to yield 15% interest annually. This was the important thing assumption of the model that affected the valuation. As an analyst, you are usually not paid to ask critical questions, however it gave the look of a wierd business model.
The IPO never happened. Shortly afterwards, the worldwide real estate market collapsed, which was hardly surprising given such projects. But I learned how sensitive DCF models are to key assumptions. These are typically growth rates for forecasting revenues and expenses, and the fee of capital for discounting future money flows to the current.
Interest rates have a serious impact on the valuation of such corporations. The lower the discount rate, the upper the valuation needs to be. With rates of interest falling worldwide and reaching historic lows, we will expect a brand new regime of record high stock price multiples across all markets.
Of course, relationships in finance are rarely linear, and we have now good data sets to check this theory.
Interest rates and P/E ratios on the US stock market
From 1900 to 1970, rates of interest fluctuated inside a comparatively narrow range between 3% and 5%, as shown by data from Robert J. ShillerIt was a turbulent time marked by the Great Depression and two world wars. As inflation picked up within the Nineteen Seventies, rates of interest rose to fifteen% before starting their long downward trend to almost zero.
In contrast, equity multiples, as measured by the cyclically adjusted price-to-earnings (CAPE) ratio, have had much shorter cycles of peaks and troughs. However, the chart below shows that equity multiples were very low when rates of interest peaked in 1980. This may provide visual support for the idea that rising bond yields result in lower corporate valuations.
Interest rates and P/E ratios on the US stock market
But frequent chart-gazing often leads the mind to false conclusions. We are usually not nearly as good at spotting patterns as we expect we’re. So what if we calculate the typical price-earnings ratios of US stocks for the period from 1871 to 2020 and divide them into quartiles based on 10-year US Treasury yields?
The average P/E ratio was 15.8 and there have been little differences in equity multiples between periods of high and low rates of interest. There was actually no linear relationship between low yields and high P/E ratios.
Interest rates and P/E ratios on the US stock market by quartile, 1872–2020
Interest rates and equity multipliers worldwide
While there may be little evidence of a connection between the 2 metrics, the statement period of 150 years is kind of long. In addition to the 2 world wars and the Great Depression, it also included the Cold War, the gold standard and all kinds of financial and economic crises. Perhaps that bears little resemblance to today. The current period is an era of relative peace with a globally interconnected economy and highly efficient capital markets fastidiously managed by central banks.
Here, Japan may provide some insights. From a monetary perspective, the country has a head start on the remaining of the world, having lived in a low rate of interest environment since about 2000. Perhaps it might probably offer a more up-to-date perspective. Japan experienced stock and real estate bubbles that imploded within the early Nineties. The aftermath – exceptionally high P/E ratios – lasted until the turn of the century.
But Japanese capital markets are seeing falling bond yields and falling stock prices. Interest rates have been zero since 2016 and P/E ratios are anything but extreme.
Interest rates and P/E ratios on the Japanese stock market
Looking at Europe and the German stock market, the typical P/E ratio of the DAX index was elevated around 2000 resulting from the boom in technology stocks, but thereafter it mostly fluctuated in a spread between 10 and 20 times.
During the identical period, the yield on 10-year German government bonds fell steadily from around 6% to currently almost -1%. As with the information from the US and Japan, there appears to be no connection between rates of interest and stock prices.
Interest rates and P/E ratios on the German stock market
Further considerations
Although applying a lower discount rate in a DCF increases valuation, it assumes that money flows remain unchanged. This is in fact a flawed assumption and explains why there isn’t any strong negative relationship between rates of interest and equity multiples.
Lower rates of interest are frequently a symptom of lower economic growth, which in turn means a less attractive outlook for the economy and its components. The good thing about discounting money flows with a lower cost of capital is mitigated by lower expected money flows.
However, P/E ratios have risen across all stock markets since 2018. Isn’t this a sign that low rates of interest justify high valuations?
The short answer is not any. It shouldn’t be statistically significant and may perhaps be explained just by animal spirits. Elon Musk’s Tesla is a primary example. The company has a market capitalization larger than most of its competitors combined, but produces only a fraction as many cars. Such euphoria eventually fades and valuations revert to the mean.
Lower rates of interest might result in higher stock prices, but only up to some extent. If rates of interest fall to 0% or below, bonds will not serve a purpose in asset allocation, and investors will subsequently have to rethink traditional allocation models.
All the capital invested in fixed income must be reallocated, and there continues to be loads of room for a revaluation of equities and other asset classes. The high valuations of start-ups and robust capital flows into private equity reflect this. It may even be time to revisit the IPO plans of that Kuwaiti real estate company.
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Photo credit: Getty Images / wonry
