I don’t understand why lower discount rates are good for equities. I realize that yield and price are inversely proportional. Is it simply that the increase in price today due to low inflation continues into the future due to the lower discount rate of future money?
It’s just the math of discount rates. If you have a projected future earnings stream (that remains constant in nominal terms), discounting it back to present value at a lower rate makes that stream of cash flows worth more in today’s money. An example is $100 in 10 years’ time discounted at 5% per annum versus 10%. The 5% scenario is a lot more favourable.
The key (false) assumption is that the lower discount rate doesn’t imply a lower earnings stream in both nominal and real terms. So far, this cycle the opposite has been true of course. The earnings stream has increased AND yields have come down- a double benefit. How long it lasts is the question.
Are you describing earnings stream for financial institutions only? Where do small and medium sized businesses fit into this picture? Sorry to ask so many questions.
Not just banks but all corporations. A big discussion point has been the persistently high margins in business in the US and the fact that they have not reverted to the mean but stayed elevated.
I don’t understand why lower discount rates are good for equities. I realize that yield and price are inversely proportional. Is it simply that the increase in price today due to low inflation continues into the future due to the lower discount rate of future money?
Could this lead to over-confidence in equites?
It’s just the math of discount rates. If you have a projected future earnings stream (that remains constant in nominal terms), discounting it back to present value at a lower rate makes that stream of cash flows worth more in today’s money. An example is $100 in 10 years’ time discounted at 5% per annum versus 10%. The 5% scenario is a lot more favourable.
The key (false) assumption is that the lower discount rate doesn’t imply a lower earnings stream in both nominal and real terms. So far, this cycle the opposite has been true of course. The earnings stream has increased AND yields have come down- a double benefit. How long it lasts is the question.
Are you describing earnings stream for financial institutions only? Where do small and medium sized businesses fit into this picture? Sorry to ask so many questions.
Not just banks but all corporations. A big discussion point has been the persistently high margins in business in the US and the fact that they have not reverted to the mean but stayed elevated.
Thank you, Ed. This makes sense.