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  • Curve Advisor
    Keymaster
    Post count: 612
    #1775 |

    EQUITIES SHOULD BE HIGHER WHEN RATES ARE LOWER (all other things being equal)

    Why is this the case? One way of valuing a company is by a “discounted cash flow” method. You take the company’s cash flow and you discount it back to the present. If rates are really low, you actually get a much higher value for the company using discounted cash flow.

    Consider this very simple example. The present value if $1 a year for 25 years is worth $14.09 at 5% (all things being equal), at 2%, the value is $19.52. So in the 2% rate assumption, the value of the cash flow is 38.5% higher than in the 5% assumption.

    This implies that something like a P/E ratio is not comparable between periods with different rate environments. A P/E ratio completely ignores the discount rates. So “all other things being equal,” if rates are lower, you should expect P/E ratio to be higher. Of course, if rates are low because we are in a recession, then you would expect earnings to take a hit, and all other things would NOT be equal.

  • Curve Advisor
    Keymaster
    Post count: 612

    Someone sent me the following link to an economist article that discusses the above:

    http://www.economist.com/blogs/buttonwood/2015/06/investing

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