Earnings, interest rates and valuations
Joel Dresang: Brian, they say time is money, and there’s the whole concept for investors of the time value of money, which essentially means that a dollar today isn’t worth what a dollar is tomorrow. How do you apply that to valuing stocks?
Brian Kilb: This is why we say the market is a discounting mechanism, Joel.
Remember what you’re doing when you’re buying a company. You’re buying an anticipated stream of earnings, right? I’m going to buy the share of this company, so I’m literally buying a share in those future earnings.
But, as you correctly point out, the dollar I earn tomorrow isn’t exactly worth the same dollar today. So I have to discount those future earnings by a discounting mechanism or an interest rate.
So, future stream of earnings discounted by an interest rate gives you a present value for that stream of earnings today.
Then I want to compare that present value, what the company’s worth in my mind, to what people are paying, what the market says people are paying. I might buy lots of it if I can get a deal, and that stock is cheap relative to what the market’s paying. I might avoid it altogether if what people are paying right now is a little more than what I think it’s worth.
Joel: You want to buy low and eventually sell high.
Brian: We go back to that every once in a while, don’t we?
Joel: And you’re looking at price-earnings ratios, for the most part?
Brian: What people use as a very general sense of measuring the overall valuation of the market – the total price of a stock, or the market, relative to the earnings of that particular company, or the market.
So as the earnings increase or decrease, my future expectations for that increase or decrease. The likelihood that I might be interested or dissuaded from buying that security certainly is relevant.
Joel: So you’re looking at expected valuations of stocks and then discounting them to a present value using interest rates. What does that mean in a low interest rate environment like we have today?
Brian: Well, it’s the interplay between the two that’s significant, right? And oftentimes in today’s environment, when we talk about earnings, we fail to recognize the interest rate environment we’re in as well.
So, in a low interest rate environment, you’re discounting by a smaller number. That allows you to pay more today for that future earnings because you’re discounting by less. So in today’s low interest rate environment, it would suggest that the markets could support a higher price.
So when we’re comparing historical price to earnings ratios, or the value of the market, to today’s, we have to take into consideration that we’re in a low interest rate environment, which naturally allows for a little higher pricing.
Joel: So how do I apply this as an investor right now?
Brian: Well, first of all, it does relate to valuations and your sense of what’s fair in the marketplace. And I think even though stocks as a price-to-earnings ratio, as a very general sense of measurement, are a little higher than norm, it’s okay, because we’re in a low interest rate environment.
Secondly, I think we have to recognize that at some point in time, interest rates are going to start to rise. And when they do, we should be sensitive to what securities in our portfolios may be impacted by those rising rates.
Joel: So that means bonds as well as some stocks?
Brian: Yes. Don’t forget that the price of bonds decreases as interest rates rise but also that certain stocks are affected by interest rate sensitivity as well.
The relationship between dividends paid out in stocks is affected by interest rates. Companies that make their living and have substantial amounts of interest-related costs in their business – companies that are highly leveraged, for instance, that have high fixed costs – those may be negatively impacted by rising interest rates as those interest rates are another cost item in the profitability or diminishing profitability of their company. So, we have to be sensitive to rising interest rates not just in bonds but in stocks as well.
Joel: So when we talk about time is money, for investors, we’re talking about interest rates and earnings, and as you point out, stock valuations.
Brian: Remember, Joel, that it’s the interplay of those three things. Right? Interest rates, earnings and market valuations that makes the difference.
Brian Kilb is executive vice president and chief operating officer of Landaas & Company.
Joel Dresang is vice president-communications at Landaas & Company.
(initially posted Sept. 2, 2016)