Myth-Busting: Low Rates Don’t Justify High Valuations

Analyzing interest rates & P/E ratios across stock markets

January 2021. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • High equity valuations are frequently justified by low interest rates
  • There is no long-term evidence in the US to support this theory
  • P/E ratios in Japan and Europe have remained low, despite zero or negative yields

INTRODUCTION

One of the more peculiar transactions I worked on as an investment banker at Citigroup was the initial public offering (IPO) of a Kuwaiti property company. This was during the 2007 real estate boom when almost every Middle Eastern nation was competing to build the tallest skyscrapers. As was often the case, the money from the IPO was needed to start construction. The plot of land was essentially a patch of desert close to Kuwait City. It required a rather vivid imagination to grasp its potential.

My job as an M&A analyst was to create a discounted cash flow (DCF) model to value the company. Given that real estate development takes time, the IPO proceeds were supposed to be invested in real estate stocks in the meanwhile. These were forecast to compound by 15% per annum. This was the key assumption in the model that impacted the valuation. As an analyst, you don’t get paid to ask critical questions, but it seemed an odd business model.

The IPO never happened. The global real estate market collapsed shortly thereafter, which given such projects was hardly surprising. But I learned how sensitive DCF models are to key assumptions, which are typically the growth rates for forecasting revenues and expenses as well as the cost of capital for discounting future cash flows back to the present.

Interest rates exert a big influence on such company valuations and the lower the discount rate, the higher the valuation should be. Since interest rates have been declining across the globe and have reached all-time lows, we should expect a new regime with record-high equity multiples for stocks across markets (read Factors & Interest Rates).

Of course, relationships in finance are rarely linear and we have good data sets at hand to evaluate this theory.

INTEREST RATES AND PE MULTIPLES IN THE US STOCK MARKET