Don't Be Fooled By The Present

A good rule of thumb when modeling firms and valuing equities is not to be fooled by the present. Normalizing growth rates, margins and discount rates attempts to estimate the value of a firm over a cycle.

Here is the problem.

In accord with financial theory, market practitioners are using the 10 yr Treasury bond (or even the 5 yr) as the risk free proxy in their DCF models. When you extrapolate linear topline growth based on the recent past (ie. the recovery out of the pit) throw in a little margin expansion (a lot actually because they are universally optimistic) and then discount the future expected cash flows at basically 1% or 2%, then a lot stocks are going to look awfully attractive. And that is where we are at right now. That is what QE does. It distorts the lens through which value is assessed.

I model with a normalized risk free rate of 5% (that assumes a real return of 3% and 2% inflation). The result is drastically different from the current consensus.

If and when the economy and markets normalize (and I think they are well on their way to doing that now) and analysts start putting higher risk free rates into their weighted average cost of capital calculations, then you are going to see large headwinds for valuations (ie. target prices). That doesn't even take into account the cost of rising interest rates on the actual cash flows of a business funding off shorter term debt.

It has been a free ride for a while, but you want to get off that train before it jumps the tracks. With the Fed on hold until at least 2014 and maybe into 2015 (depending upon economic activity and the level of unemployment), then it might still be a while before that transition takes place. Having said that, the market will in all likelihood anticipate the future rise of rates and begin factoring it into models before we see the actual change.