Discount dynamics on equity valuation
The venture capital investor Bill Gurley said in late April that entire generation of entrepreneurs and technology investors will learn equity valuation the hard way and that the “unlearning” process could be painful, surprising and unsettling to many, and that he anticipates denial. Equity valuations like interest rates have had one direction only culminating in late 2020 and early 2021. But with rising interest rates and inflation the entire equity valuation game is changing and investors will demand business models that can break-even faster than before.
To get a sense of what the US interest rate move is doing to equity valuations let us look at a very simplified example. We have a company (no debt and no non-operating assets), growing revenue at 20% p.a. for 10 years with a NOPAT (net operating profit after tax) margin of 20% with a reinvestment rate of 10% per incremental revenue. The equity risk premium is 5% and in the first period the risk-free rate is 0.5% (equivalent to the US 10-year yield in 2020). The present value of those future free cash flows including the terminal value (the present value of continuing value) is $1,359 equating to a 1-year forward free cash flow yield of 1.6%. What happens to this company if everything is unchanged except for the risk-free rate moving from 0.5% to 3.2%? The value of those future cash flows drop to $831 and the equity valuation (1-year free cash flow yield) goes to 2.6%. The drop in equity value is equivalent to 39% for a 2.7%-points move in the risk-free rate which equates to an equity duration of 14x.
Anyone that knows equity valuation dynamics understand the importance of continuing value (terminal value). The dynamic that is amplifying the moves in equity valuation when you have a large correction in technology stocks is that technology investors are beginning to cut their expectations for the long-term outlook for margins and reinvestment rate etc. so the upward move in interest rates are amplified through several factors in the modelling of the present value of future cash flows.