The stock market's 80% surge since its March 2020 low has prompted many companies to trade on high price-earnings multiples compared to their long-term averages.
A number of factors have catalyzed their rise, including low interest rates. They provide a low discount rate when valuing the present value of a company's future cash flows. This increases today's value of a firm's future cash flows compared to when a higher interest rate was previously present.
Low interest rates also make other assets, such as bonds and cash, less appealing than equities on a relative basis. This naturally increases demand among investors for stocks and reduces demand for fixed-income assets. As such, it is easier to justify high stock valuations when interest rates are low.
This point was highlighted by Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) vice chairman Charlie Munger (Trades, Portfolio) in the Daily Journal (DJCO, Financial) annual shareholder meeting in February 2021. When asked about today's high stock market valuations and the low returns currently available from cash, he said:
"I think everybody is willing to hold stocks at higher price-earnings multiples when interest rates are as low as they are now. And so I don't think it's necessarily crazy that good companies sell at way higher multiples than they used to."
A margin of safety
I think Munger's comments are helpful in highlighting that comparing today's company valuations to their historic averages may be of limited use. Interest rates are currently at an extreme level compared to any other point in history. This means a historic evaluation of company valuations may not be as insightful in determining a stock's investment appeal as it was in the past.
However, this does not mean that investors should be willing to pay any price multiple in the current stock market environment. Accepting relatively high price multiples can easily turn into overpaying for a stock, which may be detrimental to long-term returns. As such, it is crucial to continue purchasing only those stocks that trade at substantial discounts to their intrinsic values. Indeed, Munger went on to discuss this point at the Daily Journal annual meeting. He said:
"On the other hand, as you say, I didn't get rich by buying stocks at high price-earnings multiples in the midst of crazy speculative booms."
A changing outlook
In my view, obtaining a margin of safety when buying stocks continues to be crucial. Interest rates may be low today. However, they could rise in future if risks such as higher inflation come into existence and encourage a tighter monetary policy. The impact of this on stock valuations could be extremely negative.
Moreover, ongoing threats such as the pandemic, global geopolitical risks and tax rises could have a detrimental impact on the stock market's future performance. Investors who only buy stocks that offer wide margins of safety may be better protected against a changing economic and stock market environment.
Therefore, a low interest rate environment may naturally mean stock valuations are higher than they have been for many years. However, guarding against overpaying for stocks and obtaining a favorable risk/reward ratio may remain imperative in allocating capital efficiently.
Disclosure: The author has no position in any stocks mentioned.
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