With so much negativity around closed-up economies, city lockdowns, finding a vaccine, one can’t help but wonder why valuations — especially for tech firms — are sky rocketing.
Long term over short term
In any asset pricing exercise, there are two fundamental parameters to look at: future free cash flows and the discount rate.
The future free cash flows of the assets are whatever anyone thinks it to be: three, five or even ten years out. The discount rate addresses the question of “what is my expected return for purchasing a certain stock vs putting my money into a safe haven such as a government bond”.
If you look at consensus data over the next 12 months, nearly every analyst on Wall Street is predicting a decline in revenue and earnings, for a good reason — sluggish economic growth, deferred order books, and overall lower discretionary spending. This indirectly tells us that, based on the performance of the NASDAQ,
No one is bothered with what happens over the next 12 months when it comes to valuation.
Because investors are not relying on the near-term outlook for guidance, the pricing of today’s tech stocks are driven by one of the two:
- Future cash flows over the longer term; or
- Just pure hokum.
If you think about it intuitively, valuing businesses based on the data estimates looking out 3 to 5 years becomes a more viable alternative because no one can meaningfully price any business under circumstances today. Times are unprecedented; It is an anomaly, a black swan scenario. Applying the 1-year forward multiple to value a business just does not make any sense. This is similar in 2000 where the surge in prices of technology and Internet firms resulted in many investors rushing in to cash-in on the tremendous growth opportunities offered.
Therefore the pricing observed in the current market is a reflection of investors projecting incomes based on estimates 2 to 3 years out. The DCF models are for 10-years and they are willing to pay even if the earnings today were crappy.
Discount rates reflect opportunity costs
Government bonds have been widely accepted as the basis for pricing assets. It is considered to be default-free and therefore commonly used as the “risk-free” rate in valuation models. All cash flow valuation models that use the discount rate are based off this simple concept. At the peak of the dot com bubble, the 10-year treasury yield — which was the benchmark for a “safe haven” and a default-free investment — hovered at between 5 to 6%.
At some point of time, investors started to doubt the rich valuations of these Internet firms, and decided they were much better off putting their money in either government bonds that gave decent returns of 6.0%, or invest in the broader market, represented by the S&P 500. One thing led to another and the bubble burst.
The key difference between 2000 and now is that treasury yields today are trading at 0.72%. Which means that investors who decide to cash out from their richly valued stocks get effectively next to nothing if they buy bonds or other fixed income instruments. That, in part, is what is keeping the bubble inflated today.
In addition to that, city and country wide lockdowns from the pandemic have posed a serious risk for global trade and growth. Essentially, no trading = no growth. No growth = no inflation. To climb out of this economic rut, governments around the world have committed to keeping the near-to-mid-term interest rates low (read the Fed’s recent announcement in August about its inflation rate policy).
So it is against this backdrop of a grim economy, the lack of other options in putting money to work and choice of taking a much longer term view on cash flows, that many investors are dumping money in equities.
As I am writing this, I do realize that there are wide ranging perspectives from different people out there, as well as numerous datasets that when aggregated and analyzed, could also be used to explain the current phenomenon. But the market is irrational, inefficient, unpredictable. And I have never been a good trader. Only time will tell if we are in the early stages of a new age of growth or if bubble will eventually burst.