I rarely watch CNBC. That wasn’t always the case. I watched it in the early 90s when Neil Cavuto was the network’s rising star. He was very good and had some interesting guests. Things have changed a lot since then. Of course Neil is no longer with CNBC and the guests are, well, let’s just say a lot of them are a little too promotional for me. When I do watch CNBC it’s usually in a common area, like a gym. Today was one of those days as I watched from a treadmill.
The segment I was watching started by saying stocks were trading at 25x earnings. I thought, “Wow, they must be using GAAP earnings, not adjusted non-GAAP.” And they were, which immediately got my attention and increased my respect for the host and the network (even better if they used GAAP cyclically adjusted P/E, but I’ll take what I can get). Had something changed while I was away? Unfortunately nothing has changed. It was just a teaser before the good stuff began.
The host went on to say while stocks look expensive based on GAAP earnings, if you look at it from projected (non-GAAP) earnings, stocks are “only” trading at 17x earnings. The host then opined that above average valuations may be irrelevant given low bond yields. This was the setup before turning to the guest. As 9 out of 10 portfolio managers that appear on CNBC do (I have no data supporting this), the guest began to tell investors that there is no alternative (T.I.N.A.) to stocks. I immediately grabbed the remote and searched frantically for Bloomberg TV, which isn’t much better, but I like their scrolling headlines.
Is this the best the investment management industry has to offer? There is no alternative? And I thought “The New Economy” rational in 1999 was looney. Will T.I.N.A. be in the new fiduciary duty rules? Always act as a fiduciary…unless of course there’s no alternative, then do whatever you want with other peoples’ money. In my opinion, T.I.N.A. is just one more excuse, or easy to understand one-liner, to help sell and justify overpaying near the peak of a cycle. There may not be an alternative for central banks (to keep the game going) and relative return investors (to keep playing the game), but absolute return investors have a choice.
The logic behind T.I.N.A. goes like this. Because rates are so low and are expected to stay low indefinitely (so they say), it’s acceptable to alter valuation variables to make stocks appear more attractive. A high quality stock is essentially a perpetual bond with a variable coupon. How you value a perpetual bond is simple. It’s cash flow divided by discount rate (CF/k). Forgive me if this is review for many of you, but we have a few readers who majored in psychology (they probably tend to be better investors than finance majors).
Let’s assume you have $100 in annual cash flow and you demand 10% return on investment. Let’s also assume the cash flow is stable indefinitely. In this case, the value of this perpetual stream of cash flow is $1,000. With interest rates so low, the theory is an investor should reduce the discount rate, or required rate of return. If the investor lowers the required rate of return to 5% from 10%, the value of the same stream of cash flow jumps to from $1,000 to $2,000. This is what has happened to stocks this cycle. We’ve had huge multiple expansion, which is another way of saying investors are requiring less return to assume the same risk. They are doing this because apparently “they have no alternative”.
Here’s the problem with lowering investment standards, and in this case, lowering the required rate of return assumption. When valuing risk assets, the discount rate is used to measure risk or the uncertainty of an investment’s future cash flow. As I illustrated in previous posts, risks to company cash flows are alive and well. After Q2 we’ll have had five consecutive quarters of negative earnings growth. If risks to cash flows haven’t been reduced, why should an investor demand a lower return on investment? Businesses are not risk-free and shouldn’t be valued as such. Furthermore, I don’t believe artificially suppressed risk-free rates should be the starting point or foundation of a business valuation.
To think about this in simple terms, pretend you own a pizza shop (during asset bubbles I often imagine making pizzas instead of fighting the Fed). You buy the pizza shop for $200,000 and it generates $50,000 a year in cash flow. So you’re receiving a 25% return on your investment assuming cash flows remain stable. But stable cash flows is a dangerous assumption when running a business and that’s why you’re requiring a much higher return on capital than a risk-free rate (also known as a risk premium). Do you care about risk-free interest rates? Maybe if you borrowed to buy the pizza shop or if your lease is tied to interest rates in some way, but for the most part you’re much more concerned about operating risks.
Cheese prices are volatile and a major cost. Minimum wage is increasing. Oh no, the health inspector just shut you down for a week. Papa John’s and Little Caesars are both opening next door – pizza price wars! Pizza ovens burn a lot of natural gas. Your delivery guy just ran over a $5,000 poodle. Your building was just bought by a private equity firm that overpaid and they are raising your rent 20%. The kid running the cash register is missing and so is the cash. All of a sudden the positive $50,000 cash flow you were valuing is now negative -$50,000. Is your business still worth $200,000?
In effect, are risk-free rates relevant to your pizza shop valuation? I don’t think so. In my opinion, operating risks of a business are the most important risks to cash flows and it is the risk to cash flows that should determine an investor’s required rate of return, not risk-free rates. I prefer using a required rate of return that consists of what I’d lend to a business and then apply an equity risk premium on top of that (combined it’s typically 10-15% discount rate). Granted this valuation technique remains subjective, but it makes much more sense to me.
For those who continue to insist the risk-free rate should be the foundation of business valuation (academic version and often used by those with perfect SAT scores), the math still doesn’t work. If one were to use a low discount rate based on low risk-free rates, they must also assume risk-free rates stay depressed indefinitely. If we assume interest rates stay depressed indefinitely, shouldn’t we also assume growth rates remain depressed? Isn’t subpar growth in domestic and global economies the reason risk-free rates are low? You can’t have it both ways — if you use a lower required rate of return due to abnormally low risk-free rates, you can’t also assume normal growth rates. In theory, the lower growth rate would offset the valuation benefit from the lower discount rate (CF/k-g).
We’ll get back to actual businesses and operating results tomorrow, but I thought it was important to touch on why lowering valuation standards doesn’t make sense to me. I believe T.I.N.A. is just another end of the cycle excuse to overpay, or one more version of this time is different. When has lowering your standards ever worked in life? Why do it with your money, or even worse, someone else’s money. No more CNBC for me! However, a pizza sounds good.