Are Stocks Overvalued

We could also have entitled this essay How to Measure Your Own Capital Destruction. But this headline would not have set expectations correctly. As always, when looking at the phenomenon of a credit-fueled boom, the destruction does not occur when prices crash. It occurs while they’re rising. But people don’t realize it, then, because rising prices are a lot of fun. They don’t realize their losses until the crash. So we want to look at stocks when they’re high, before people realize what’s happened to them.

How do you value a stock? The classic methodology, proposed by Benjamin Graham and Warren Buffet, is to discount future free cash flows. Let’s leave aside the problem of how to predict future revenues much less cash flows in our crazy resonant system with positive feedback. For purposes of this discussion, we will just assume that a stock generates a known and constant cash flow of, say, $1 per year, in perpetuity.

What is this worth? A dollar today is worth, well, a dollar today. But what about a dollar to be paid next year? You need to discount it. Suppose you use a discount rate of 10%. In that case, the next-year dollar is worth $0.90 today. The two-years-hence dollar is worth $0.81 today. And so on. If you studied calculus at university, you will recognize where this is going. It’s the sum of an infinite series:

1 + 0.91 + 0.81 + 0.729 + $0.656 + … which has a finite value. $10.

As an aside, it has become popular to call everything a bubble, including even behaviors that do not have a price. Such as university attendance, or student loan debt. If we want to be a bit more rigorous in our use of words, we would use the word bubble to mean when the price of an asset has gone above its value. Such as the value given by this series.

Anyways, back to calculating the present value for equities. What should one use for the discount rate? We have argued many times that it is the market interest rate.

If the rate falls from 10% to 5%, then notice that the present value doubles from $10 to $20.

Clever readers are now saying, “Wait a minute! If value is calculated based on the market interest rate, and the rate falls, then how is one to say stocks are in a bubble? What is the fair value of a stock anyways??”

That is, indeed, the problem.

If the Fed can manipulate the rate of interest, then it can manipulate the value of everything. The English language does not contain a word sufficient to describe the hubris, pernicious harm, sheer folly—and evil—of this.

The Fed cannot alter reality—but it can distort your perception of reality! One might be tempted to say, “Well I won’t be fooled, I won’t use the Fed’s distorted interest rate to discount future earnings.” OK, that’s great. But what will you use?

There is no other rate to use, other than the market rate. You don’t know the right rate any better than the people who centrally plan our economy. The problem is not that the wrong people are in the job. The problem is not even that they use the wrong magic formulas to determine what rate to set.

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Disclaimer: This content is provided as general information and for educational purposes only and should not be taken as investment advice. We do not guarantee the accuracy and/or completeness of the ...

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