Stock Market Pricing and Interest Rates
Posted: Mon Nov 02, 2020 11:34 pm
In the stock market, shares trade at 10-12x earnings regardless of where interest rates are at. This is mostly fine, but can end up getting screwy as time goes on. When inflation slows, interest rates can fall to near zero. This means that a share will yield 10% ( 1 / 10x P/E) while debt only costs 3% (just an example). In this case, it is always worth it to borrow and buy equity. (Even if you have to purchase from the AI at a premium! (10x * 150% = 15x , 1 / 15x = 6.7% > 3%))
The reverse is also true. If interest rates are sky high, issuing equity and buying bonds will be accretive to equity. For example issuing at 10x P/E and buying bonds at >10% will be accretive, regardless of your own credit rating.
The issue becomes very apparent if rates fall below 5% and one goes to purchase a private company. As I understand it, the price of acquiring a private company is (Earnings / 5% + Cash). For instance a company with $100m in earnings and $200m in cash can be bought for ($100m/ 5% +$200m = $2200m) If rates are below 5%, say 3%, a player can borrow $2200m, and buy the company for a guaranteed return of $40m / yr ( $100m - ($2200m of debt - $200m cash) * 3% = $40m ) If the player is publicly traded this tactic would add $400m ($40m * 10x P/E) in market cap.
On a similar note, if interest rates are high, it is almost never worth it to purchase a private company.
The multiples that companies trade at should be linked to interest rates.
A formula similar to the CAPM model (https://www.investopedia.com/terms/c/capm.asp) could be used to determine the appropriate multiple. A setting in the game start menu could be added to determine the market risk premium. For instance, if the base rate is 5%, and the market risk premium was set to 5%, the P/E would still be 10x (5% + 5% = 10% , 1 / 10% = 10x P/E). But, if rates were to fall to 3%, the same company would then trade at 12.5x (3% + 5% (market risk premium) = 8% , 1 / 8% = 12.5x).
The reverse is also true. If interest rates are sky high, issuing equity and buying bonds will be accretive to equity. For example issuing at 10x P/E and buying bonds at >10% will be accretive, regardless of your own credit rating.
The issue becomes very apparent if rates fall below 5% and one goes to purchase a private company. As I understand it, the price of acquiring a private company is (Earnings / 5% + Cash). For instance a company with $100m in earnings and $200m in cash can be bought for ($100m/ 5% +$200m = $2200m) If rates are below 5%, say 3%, a player can borrow $2200m, and buy the company for a guaranteed return of $40m / yr ( $100m - ($2200m of debt - $200m cash) * 3% = $40m ) If the player is publicly traded this tactic would add $400m ($40m * 10x P/E) in market cap.
On a similar note, if interest rates are high, it is almost never worth it to purchase a private company.
The multiples that companies trade at should be linked to interest rates.
A formula similar to the CAPM model (https://www.investopedia.com/terms/c/capm.asp) could be used to determine the appropriate multiple. A setting in the game start menu could be added to determine the market risk premium. For instance, if the base rate is 5%, and the market risk premium was set to 5%, the P/E would still be 10x (5% + 5% = 10% , 1 / 10% = 10x P/E). But, if rates were to fall to 3%, the same company would then trade at 12.5x (3% + 5% (market risk premium) = 8% , 1 / 8% = 12.5x).