Half-Truths Are Half Lies By Definition

Half-Truths, Half-Truths Are Half Lies By Definition

A lower discount rate applied to future earnings boosts valuations. However, one must also assume a slower growth rate for earnings projections. When both growth rates are appropriately adjusted, the benefit of a lower discount rate is largely offset by a slower expected earnings growth rate.  

The blue dots in the graph below show the present value of a stream of future cash flows growing at 5% per selected discount rates. The orange line is similar, but it assumes a 4% cash flow growth rate.

As highlighted in the box with the red arrow, if the discount rate is lowered by 1% with no change to expected earnings growth, the present value rises by 18%.  However, if we lower expected earnings and the discount rate by 1%, the black arrow shows that the present value increases by a mere 1%.

Half-Truths, Half-Truths Are Half Lies By Definition

A lower discount rate is only bullish if no adjustments are made to earnings growth forecasts.  The problem is yields, discount rates, and corporate earnings are directly tied to the economy.

The story is not as compelling when facts are equally applied.

Summary

Walk down the cereal aisle in any grocery store and read about the nutritional benefits of most cereals. The boxes are partially correct. Most breakfast cereals have an assortment of beneficial vitamins and fiber. Many also have unhealthy amounts of sugar.

The aisle for stocks is similar. As investors, we continually see half-truths. Most current investors are lazy and do not want to research the veracity of claims or what might not be exposed.

The fact of the matter is that half-truths sell, and in a bullish market, that is all investors want to hear.

1 2 3
View single page >> |

Disclaimer: Click here to read the full disclaimer. 

How did you like this article? Let us know so we can better customize your reading experience.

Comments

Leave a comment to automatically be entered into our contest to win a free Echo Show.