As reflected in the underperformance of the technology heavy Nasdaq Composite index, high growth shares are sensitive to interest rates due to the fact a big chunk of their value is based on cash flows far into the future.

It’s not just growth shares though, all shares are impacted by rising interest rates through the mechanism of a higher discount rate.

But have markets discounted the full impact of higher rates? Arguably, falls of 1% in the FTSE 100, 18% in the DAX and 20% in the S&P 500 over the past 12 months look tame relative to the quantum leap in interest rates.

Market strategists at Morgan Stanley and Goldman Sachs are in the camp arguing for a bigger market derating before a market bottom has been reached.

This article takes a closer look at the dynamics of discounted cash flow and the findings suggest markets are vulnerable to further erosion in the ratings at which stocks trade.

DISCOUNTED CASH FLOW

Discounted cash flow is a common investment approach used to value companies in the stock market. It is based on shareholders’ claims on a firm’s cash flows.

The idea is to add up estimated future cash flows, discount them back to a ‘present value’ and compare it with the current share price. If the price is below the value of a firm’s discounted cash flows, the share is cheap and vice-versa.

WHY ARE CASH FLOWS DISCOUNTED?

Future cash flows are discounted (reduced) for two reasons; first, because of the uncertainty of them occurring and second, due to the opportunity cost of capital.

Opportunity cost refers to the idea that if the capital is not invested in shares, it could earn a risk-free rate of return in government bonds.

WHAT IS AN APPROPRIATE DISCOUNT RATE?

To answer the question some context is needed because the discount rate is comprised of a risk-free rate and a risk premium, which are explained below. But first, some context.

Up until 2021, government bonds yielded close to zero, even at the 10-year investment horizon, and many bonds traded with negative yields. It may sound crazy today but not long ago, investors were willing to pay borrowers to lend them money.

Ultra-loose monetary policy led to a cost of capital which was virtually zero. But historically 10-year bond yields have traded on average at close to 4% in most developed economies.

Theoretically, zero risk-free rates reduce the return that investors expect to receive which makes higher growth shares more valuable. This was a strong driver of rising price to earnings ratios for growth companies.

Investors were happy to pay 30, 40 or even 50 times expected earnings to own a stock that offered the promise of rapid growth in the future. Today they are less willing to pay such multiples                      of earnings.

RISK PREMIUM

The risk premium is related to the idea that investors in shares demand a higher return than bonds because they are taking more risk.

The equity – which is another word for stocks and shares – risk premium is measured by comparing long-term share and government bond returns. Historical studies have shown the extra annual return earned by shares has ranged between 4% and 6%.

WHAT DOES A RISING DISCOUNT DO TO SHARE VALUATIONS?

Ten-year bond yields (i.e., risk-free rates) have increased by up to four percentage points in the US and UK over the last year. Assuming the risk premium has remained the same then taking the mid-point of the historical average (5%) implies a four-percentage point increase in the discount rate to 9%.

To illustrate the impact of a four-percentage point increase in the cost of capital for a growth company, Shares has used an annual growth rate of 15% for cash flows over a 10-year time horizon.

Growth at 15% means £100 of cash flow will quadruple over 10 years. The rule of 70 can be helpful here. Simply divide the growth rate (15%) into 70 to estimate how many years it would take to double.

The answer is roughly five years, which means over 10 years the cash flow will double again. Each year’s cash flow must be discounted by the 5% rate, compounded each year.

As illustrated in the table, in year one cash flow of £115 is discount by 5% (divided by 1.05), year two cash flow of £132 is discounted by 1.05x1.05=1.1025 and so on.

Present value cash flows are then calculated. The year 10 discount rate is 1.6289 which reduces the value of that year’s cash flow by around 40% to £248.

Total cash flows add up to £1,706. Remember, cash flows can theoretically go on forever, so a value needs to be placed on them.

The simplest way is to do this is to perform a perpetuity calculation. Year 10 cash flow is multiplied by the inverse of the discount rate (5% = 20 times) and then divided by the year 10 discount rate of 1.6289.

The process is repeated using 9% cost of equity and table two shows the present value falls by half. Also note the bulk of the fall sits in the perpetuity calculation. In other words, cash flows far into the future are impacted the most.

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