Inflation, Interest Rates and Risk Premiums in Valuations

Inflation, Interest Rates and Risk Premiums in Valuations

When i look at newspapers/websites, the main topics for discussion are ๐ข๐ง๐Ÿ๐ฅ๐š๐ญ๐ข๐จ๐ง, ๐ข๐ง๐ญ๐ž๐ซ๐ž๐ฌ๐ญ ๐ซ๐š๐ญ๐ž๐ฌ, ๐ญ๐ก๐ž ๐ฉ๐ซ๐จ๐›๐š๐›๐ข๐ฅ๐ข๐ญ๐ฒ ๐จ๐Ÿ ๐ซ๐ž๐œ๐ž๐ฌ๐ฌ๐ข๐จ๐ง ๐š๐ง๐ ๐ก๐จ๐ฐ ๐ ๐ฅ๐จ๐›๐š๐ฅ ๐ž๐ช๐ฎ๐ข๐ญ๐ข๐ž๐ฌ ๐š๐ง๐ ๐œ๐ซ๐ฒ๐ฉ๐ญ๐จ๐œ๐ฎ๐ซ๐ซ๐ž๐ง๐œ๐ข๐ž๐ฌ ๐ก๐š๐ฏ๐ž ๐œ๐ซ๐š๐ฌ๐ก๐ž๐ in 2022. If i have to summarize, there is fear in the market.

In finance, ๐—ฟ๐—ถ๐˜€๐—ธ = ๐—ฑ๐—ฎ๐—ป๐—ด๐—ฒ๐—ฟ + ๐—ผ๐—ฝ๐—ฝ๐—ผ๐—ฟ๐˜๐˜‚๐—ป๐—ถ๐˜๐˜†,

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 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 ๐—๐—ฎ๐—ป ๐Ÿญ ๐Ÿฎ๐Ÿฌ๐Ÿฎ๐Ÿฎ, 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 ๐—๐˜‚๐—น ๐Ÿฑ ๐Ÿฎ๐Ÿฌ๐Ÿฎ๐Ÿฎ, the numbers are:

The 10 yr treasury bond in US rate = 2.82%, ๐˜‚๐—ฝ ๐—ฏ๐˜† ๐Ÿด๐Ÿณ%๐—ผ๐˜ƒ๐—ฒ๐—ฟ ๐—๐—ฎ๐—ป ๐Ÿญ ๐Ÿฎ๐Ÿฌ๐Ÿฎ๐Ÿฎ

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 ๐Ÿด๐Ÿฐ.๐Ÿฏ% ๐—ผ๐—ณ ๐—ฒ๐—ฎ๐—ฟ๐—ป๐—ถ๐—ป๐—ด๐˜€ ๐—ฎ๐˜€ ๐—ฏ๐˜‚๐˜†๐—ฏ๐—ฎ๐—ฐ๐—ธ ๐—ฎ๐—ป๐—ฑ ๐—ฑ๐—ถ๐˜ƒ๐—ถ๐—ฑ๐—ฒ๐—ป๐—ฑ๐˜€ to investors.

As of yesterday, S&P 500 index closed at 3831.39; solving for these inputs, i derive the ๐ž๐ช๐ฎ๐ข๐ญ๐ฒ ๐ซ๐ข๐ฌ๐ค ๐ฉ๐ซ๐ž๐ฆ๐ข๐ฎ๐ฆ ๐Ÿ๐จ๐ซ ๐”๐’ ๐ž๐ช๐ฎ๐ข๐ญ๐ข๐ž๐ฌ = ๐Ÿ“.๐Ÿ’๐Ÿ%

Thus, the expected return from equities ๐—ถ๐—ป๐—ฐ๐—ฟ๐—ฒ๐—ฎ๐˜€๐—ฒ๐—ฑ ๐Ÿฐ๐Ÿฏ.๐Ÿฑ%, ๐—ณ๐—ฟ๐—ผ๐—บ ๐Ÿฑ.๐Ÿณ๐Ÿฑ% ๐—ถ๐—ป ๐—๐—ฎ๐—ป ๐Ÿฎ๐Ÿฌ๐Ÿฎ๐Ÿฎ ๐˜๐—ผ ๐Ÿด.๐Ÿฎ๐Ÿฐ% ๐—ถ๐—ป ๐—๐˜‚๐—น๐˜† ๐Ÿฎ๐Ÿฌ๐Ÿฎ๐Ÿฎ, ๐—ฟ๐—ฒ๐—ณ๐—น๐—ฒ๐—ฐ๐˜๐—ถ๐—ป๐—ด ๐—ต๐—ถ๐—ด๐—ต๐—ฒ๐—ฟ ๐—ณ๐—ฒ๐—ฎ๐—ฟ ๐—ถ๐—ป ๐˜๐—ต๐—ฒ ๐—บ๐—ฎ๐—ฟ๐—ธ๐—ฒ๐˜ ๐˜๐—ผ ๐—ถ๐—ป๐˜ƒ๐—ฒ๐˜€๐˜ ๐—ถ๐—ป ๐˜€๐˜๐—ผ๐—ฐ๐—ธ๐˜€.

๐‡๐จ๐ฐ ๐ฅ๐จ๐ง๐  ๐ฐ๐ข๐ฅ๐ฅ ๐ญ๐ก๐ข๐ฌ ๐Ÿ๐ž๐š๐ซ ๐œ๐จ๐ง๐ญ๐ข๐ง๐ฎ๐ž?
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/ย #TAM/ย #marketshareย 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.



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