Over the past few weeks, interest rates have begun to increase faster than expected. The yield on the 10-year Treasury has risen from 0.93% at the beginning of December to above 1% at the time of writing. That means that since August of last year, when the 10-year yield hit 0.5%, interest rates have more than doubled.
There are a few reasons why this is important for investors. Firstly, it means debt is more expensive. For both the U.S. government and corporate borrowers, the cost of borrowing money is rising.
Second, it's a sign that the market believes inflation is just around the corner. That could be bad news for some investments.
Third, rising yields suggest stocks are worth less today than they were in August of last year.
It's this last point that warrants further attention from investors. One of the most common ways of valuing equities is to calculate a company's stream of future cash flows and then discount this cash generation back to the present at an appropriate rate. Warren Buffett (Trades, Portfolio) and other investors have advocated using the 10-year Treasury rate as a benchmark.
Last year, I looked at the valuations of some of Buffett's largest holding based on this method. At the time, I calculated a prospective discount rate of between 4.53% to 3.74%, using the 10-year and 30-year rates of 0.74% and 1.53% at the time and a 3% margin.
"According to Gurufocus data, Coca-Cola's free cash flow has grown at a compound annual growth rate of 0.8% per annual for the past decade. In its last full financial year, the company reported free cash flow of $8.4 billion.
Plugging the above figures into a discount cash flow analysis gives an implied valuation of just under $68 per share at a discount rate of 3.7% and just over $53 per share at the higher discount rate of 4.5%. Both of these numbers suggest the stock is trading under intrinsic value at current levels."
So, how would these figures look today? Using the same free cash flow and growth figures, but with a discount rate of 1% plus a 3% margin, the figures show Coca-Cola's estimated valuation is $61.57 per share, a full 10% below the previous value. Apple and Kraft's estimated intrinsic values are $220 and $227.46 per share respectively.
Whichever way you look at it, these are significant changes. Just a small change in the risk-free rate has incurred a significant drop in estimated intrinsic value. This illustrates the risk of buying equities at premium valuations. Even a small change in the operating environment can have a big impact on the company's shares.
One way to get around this problem would be to buy the stocks with a reasonable margin of safety. That's something Buffett has always advocated, and it can help mitigate the challenge of uncertainty.
Many analysts expect interest rates to continue to increase over the next year as a normal part of the economic cycle. When the economy is improving, it is essential to increase interest rates in order to avoid inflation spiralling out of control.
Increased economic stimulus and borrowing could drive rates higher, and while this would be positive for many companies on a fundamental level, it is bound to hit equity valuations.
This is one of the risks investors need to be aware of as interest rates continue to grind higher. In past market downturns, it wasn't as much of a concern, but this time around we have seen the rather unique phenomenon of a stock market bull run during a major global economic recession, which puts quite a different spin on things.
Read more here:
- The 'Intellectual Laziness' of Value and Growth Investing
- Rising Levels of Debt Pose Big Problems for Investors
- A Lesson in Investing From the World of Film
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