The stock market’s 95% rise since the March 2020 crash means that many companies trade on relatively high valuations. Indeed, in some cases they are significantly greater than their long-term averages.
A key reason for this could be low interest rates. They have the effect of making income-producing assets such as cash and bonds relatively unappealing. Low interest rates also provide a potential catalyst to the economy’s future prospects that could lead to attractive operating conditions for many businesses. These factors may naturally increase demand for stocks.
In addition, today’s interest rate of 0% to 0.25% means investors use a lower discount rate when calculating the net present value of a stock’s future cash flow. This leads them to value businesses more generously than if interest rates were at a higher level.
Falling interest rates
However, a potential threat facing investors is the prospect of rising interest rates. They have never remained fixed throughout history and, with inflation having recently reached its highest level in 13 years, it would be unsurprising for the Federal Reserve to adopt a tighter monetary policy.
In turn, this could cause investors to use a higher discount rate when valuing the net present value of a company’s future cash flows. This could lead them to determine that many of today’s stock prices are overvalued, which may limit their capacity to deliver further capital growth.
Buffett’s view
Paying too much for any stock can be extremely detrimental to portfolio returns. Indeed, Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) Chairman Warren Buffett (Trades, Portfolio) has previously discussed this viewpoint.
“For the investor, a too-high purchase price for the stock of an excellent company can undo the effects of a subsequent decade of favorable business developments,” he once said.
Therefore, it is logical to ensure that a stock’s valuation can be justified in a range of future economic scenarios before purchasing it. Otherwise, it could lead to disappointing investment returns – even if the business in question is able to deliver a strong financial performance over the long run.
My take
A simple means to avoid overpaying for stocks is to demand that a margin of safety is included in its price. The amount of discount versus a stock’s intrinsic value that is required to merit purchase is clearly subjective. Different investors will demand a range of discounts depending on their own circumstances and risk tolerance. However, having a disciplined approach may mean an investor rarely, if ever, overpays for a stock.
Clearly, this task is extremely difficult in today’s buoyant stock market environment. By definition, improving investor sentiment means stock prices naturally move to levels that are increasingly difficult to justify.
However, history suggests the current bull market will not last in perpetuity and will ultimately be superseded by a bear market. Therefore, ensuring that a portfolio is prepared for a bear market, or a period of higher interest rates, by not overpaying for stocks could be crucial over the coming years.
