Basic, lesson 1 of 3
Rates and the equity multiple
A stock is a claim on cash flows far in the future, so its price moves with the rate used to discount them. Long dated cash flows move the most.
8 min, 3 checks
1Duration in equities
A bond with a long maturity loses more when yields rise. Stocks work the same way. A company whose value sits mostly in distant growth behaves like a long bond; a mature company paying most of its value out soon behaves like a short one.
Worked example
Same cash flow, different growth
- 1Both companies pay $5 of free cash flow per share next year.
- 2Growth stock: grows 6% forever. At a 9% discount rate it is worth 5 / 0.03 = $166.7. At 10%, 5 / 0.04 = $125. Down 25%.
- 3Mature stock: grows 2%. At 9%, 5 / 0.07 = $71.4. At 10%, 5 / 0.08 = $62.5. Down 12.5%.
One point on the discount rate cost the growth stock twice as much.
Check 1
A stock pays $4 of free cash flow next year growing 8% forever. If the discount rate rises from 10% to 11%, by what percent does its value fall? One decimal.
2Real yields and the risk premium
The yield that matters most for equity multiples is the real yield: the nominal yield minus expected inflation. Rising real yields mean the reward for holding safe assets is going up in purchasing power, which pulls money out of long duration stocks.
Rough equity risk premium = Earnings yield - Real bond yield
A blunt gauge. Earnings yield is the inverse of the forward P/E.
Check 2
An index trades at 20x forward earnings and the ten year real yield is 2%. What is the rough equity risk premium, in percent?
Check 3
The ten year nominal yield is unchanged, but expected inflation falls half a point. What happened, and who feels it?
Terms in this lesson: Price-to-earnings ratio.
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