One of the most peculiar transactions I worked on as an investment banker at Citigroup was the initial public offering (IPO) of a Kuwaiti real estate company. It was during the building boom of 2007, when nearly every country in the Middle East was competing to build the tallest skyscrapers. As was often the case, the money from the IPO was needed to start construction. The land was basically a patch of desert near Kuwait City. It took a pretty 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 business. Since real estate development takes time, the proceeds from the IPO had to be invested in real estate stocks in the meantime. These were to increase by 15% per year. This was the key model assumption that impacted the valuation. As an analyst, you don’t get paid to ask critical questions, but that seemed like an odd business model.
The IPO never happened. The global real estate market collapsed soon after, which, given such plans, was hardly surprising. But I learned how sensitive DCF models are to key assumptions, which are typically growth rates to forecast income and expenses as well as the cost of capital to discount future cash flows to the present.
Interest rates have a big influence on the valuations of these companies and the lower the discount rate, the higher the valuation should be. As interest rates have fallen around the world to historic lows, we should expect a new regime with record high equity multiples for equities in all markets.
Of course, relationships in finance are rarely linear and we have good datasets to test this theory.
Interest rates and P/E multiples in the US stock market
Interest rates moved in a relatively narrow range between 3% and 5% from 1900 to 1970, according to data from Robert J. Shiller. It was a turbulent period encompassing the Great Depression and both World Wars. When inflation accelerated in the 1970s, interest rates soared to 15% before beginning their long descent to almost zero today.
In contrast, equity multiples, as measured by the cyclically-adjusted price-earnings multiple (CAPE), exhibited much shorter cycles of peaks and troughs. The following chart, however, implies that when interest rates peaked in 1980, equity multiples were very low. This may provide visual support for the theory that rising bond yields drive down corporate valuations.
Interest rates and P/E ratios in the US stock market
Yet frequent reading of charts often leads the mind to the wrong conclusions. We’re not as good at pattern recognition as we think. What if we calculated the average price-earnings ratios of US stocks for the period 1871 to 2020 and separated them into quartiles based on 10-year US Treasury yields?
The average P/E ratio was 15.8x and there were only minor differences in equity multiples between periods of high and low interest rates. There was certainly no linear relationship between low returns and high P/E ratios.
Interest rates and P/E ratios in the US stock market by quartiles, 1872–2020
Interest rates and equity multiples around the world
Although there is little evidence of correlation between the two measurements, the observation period of 150 years is quite long. In addition to the two World Wars and the Great Depression, this included the Cold War, the gold standard, and all sorts of financial and economic crises. Perhaps it bears little resemblance to today. The current period is an era of relative peace, with a globally connected economy and highly efficient capital markets carefully managed by central bankers.
Here, Japan can offer insight. From a monetary perspective, it is ahead of the rest of the world, having been in a low interest rate environment since around 2000. Perhaps that can provide a more timely outlook. Japan experienced stock market and housing bubbles that imploded in the early 1990s. The aftermath – exceptionally high P/E ratios – lasted until the turn of the century.
But Japanese capital markets are showing falling bond yields as well as falling equity multiples. Interest rates have been zero since 2016 and P/E ratios are anything but extreme.
Interest rates and P/E ratios in the Japanese stock market
With regard to Europe and the German stock market, the average P/E ratio of the DAX index was high around 2000 due to the boom in technology stocks, but then traded largely in a range between between 10x and 20x.
Over the same period, the yield on the German 10-year Bund has steadily declined from around 6% to around -1% currently. As with the data from the United States and Japan, there does not appear to be a relationship between interest rates and equity multiples.
Interest rates and P/E ratios on the German stock market
Although applying a lower discount rate in a DCF increases the valuation, it assumes that the cash flows are unchanged. Of course, this assumption is wrong and explains why there is no strong negative relationship between interest rates and equity multiples.
Lower interest rates tend to be a symptom of weaker economic growth, implying a less attractive outlook for the economy and its components. The benefit of discounted cash flows with a lower cost of capital is mitigated by the reduction in expected cash flows.
However, P/E ratios have increased across all equity markets since 2018. Doesn’t that indicate that low rates justify high valuations?
The short answer is no. It’s not statistically significant and could simply be explained by animal spirits. Elon Musk’s Tesla is a prime example. The company has a larger market capitalization than most of its peers combined, but produces only a fraction of the number of cars. Such euphoria tends to evaporate and valuations to revert to the mean.
Still, lower interest rates could actually lead to higher equity multiples, but only beyond a certain point. When rates fall to 0% or less, bonds become useless in asset allocation, so investors need to rethink traditional allocation models.
All that capital invested in fixed income securities needs to be reallocated, and there is plenty of room for equities and other asset classes to be repriced. The high valuations of start-ups and the large flows of assets into private equity bear witness to this. Heck, it might even be time to dust off this Kuwaiti real estate company’s IPO plans.
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All posts are the opinion of the author. As such, they should not be construed as investment advice, and the opinions expressed do not necessarily reflect the views of the CFA Institute or the author’s employer.
Image credit: Getty Images / Wonry