- July 28, 2022
- Posted by: Ramkumar
- Category: Posts
Inflation, Interest Rates and Risk Premiums in Valuations
When i look at newspapers/websites, the main topics for discussion are 𝐢𝐧𝐟𝐥𝐚𝐭𝐢𝐨𝐧, 𝐢𝐧𝐭𝐞𝐫𝐞𝐬𝐭 𝐫𝐚𝐭𝐞𝐬, 𝐭𝐡𝐞 𝐩𝐫𝐨𝐛𝐚𝐛𝐢𝐥𝐢𝐭𝐲 𝐨𝐟 𝐫𝐞𝐜𝐞𝐬𝐬𝐢𝐨𝐧 𝐚𝐧𝐝 𝐡𝐨𝐰 𝐠𝐥𝐨𝐛𝐚𝐥 𝐞𝐪𝐮𝐢𝐭𝐢𝐞𝐬 𝐚𝐧𝐝 𝐜𝐫𝐲𝐩𝐭𝐨𝐜𝐮𝐫𝐫𝐞𝐧𝐜𝐢𝐞𝐬 𝐡𝐚𝐯𝐞 𝐜𝐫𝐚𝐬𝐡𝐞𝐝 in 2022. If i have to summarize, there is fear in the market.
In finance, 𝗿𝗶𝘀𝗸 = 𝗱𝗮𝗻𝗴𝗲𝗿 + 𝗼𝗽𝗽𝗼𝗿𝘁𝘂𝗻𝗶𝘁𝘆,
At low-interest rates and stable/growing GDP, opportunity turns to greed, and we see crazy valuations. So VCs/PE firms allocate their investments in the riskiest assets, hoping that would reward them further. As a result, more unicorns/IPOs emerge during this period.
At high-interest rates and declining GDP growth, danger turns to fear. As a result, investors pull their investments from risky assets like startups/high-growth firms/cryptocurrencies and allocate them to safer assets (bonds, stable companies). Fundamentals and valuations become hot topics rather than pricing because the objective is to earn returns to justify higher interest rates.
On 𝗝𝗮𝗻 𝟭 𝟮𝟬𝟮𝟮, the risk-free rate/10 yr treasury bonds in the US = 1.51%, and the equity risk premium (the return investors expected for investing in equities) = 4.24%.
For 𝗝𝘂𝗹 𝟱 𝟮𝟬𝟮𝟮, the numbers are:
The 10 yr treasury bond in US rate = 2.82%, 𝘂𝗽 𝗯𝘆 𝟴𝟳%𝗼𝘃𝗲𝗿 𝗝𝗮𝗻 𝟭 𝟮𝟬𝟮𝟮
The analyst forecast for earnings growth in S&P 500 companies in
2022 = 9.9% and ,
2023 = 9.7%.
In my view, this forecast is high because companies’ earnings decline during higher inflationary periods. Thus, i revise the earnings forecasts for,
2022 = 7.9%
2023 = 6.7%
S&P 500 companies return 𝟴𝟰.𝟯% 𝗼𝗳 𝗲𝗮𝗿𝗻𝗶𝗻𝗴𝘀 𝗮𝘀 𝗯𝘂𝘆𝗯𝗮𝗰𝗸 𝗮𝗻𝗱 𝗱𝗶𝘃𝗶𝗱𝗲𝗻𝗱𝘀 to investors.
As of yesterday, S&P 500 index closed at 3831.39; solving for these inputs, i derive the 𝐞𝐪𝐮𝐢𝐭𝐲 𝐫𝐢𝐬𝐤 𝐩𝐫𝐞𝐦𝐢𝐮𝐦 𝐟𝐨𝐫 𝐔𝐒 𝐞𝐪𝐮𝐢𝐭𝐢𝐞𝐬 = 𝟓.𝟒𝟏%
Thus, the expected return from equities 𝗶𝗻𝗰𝗿𝗲𝗮𝘀𝗲𝗱 𝟰𝟯.𝟱%, 𝗳𝗿𝗼𝗺 𝟱.𝟳𝟱% 𝗶𝗻 𝗝𝗮𝗻 𝟮𝟬𝟮𝟮 𝘁𝗼 𝟴.𝟮𝟰% 𝗶𝗻 𝗝𝘂𝗹𝘆 𝟮𝟬𝟮𝟮, 𝗿𝗲𝗳𝗹𝗲𝗰𝘁𝗶𝗻𝗴 𝗵𝗶𝗴𝗵𝗲𝗿 𝗳𝗲𝗮𝗿 𝗶𝗻 𝘁𝗵𝗲 𝗺𝗮𝗿𝗸𝗲𝘁 𝘁𝗼 𝗶𝗻𝘃𝗲𝘀𝘁 𝗶𝗻 𝘀𝘁𝗼𝗰𝗸𝘀.
𝐇𝐨𝐰 𝐥𝐨𝐧𝐠 𝐰𝐢𝐥𝐥 𝐭𝐡𝐢𝐬 𝐟𝐞𝐚𝐫 𝐜𝐨𝐧𝐭𝐢𝐧𝐮𝐞?
As long as inflation does not come under control, we will see fear and the movement of capital from risky assets to safer assets. Thus, i see lower capital allocation in early-stage startups/junk bonds/growth companies that burn cash.
Further, how investors price companies will change from multiples/ TAM/ market share to fundamentals (growth rate, risk and cash flows). So investors who understand fundamentals and value companies on cash flows will benefit from traders who focus on the mood and momentum of markets.