November 2021 – Valuing Securities – Part I

My colleague Joe Gallina writes informative and entertaining blog posts about cryptocurrencies. Most recently, he wrote:

With no balance sheets, no terminal value, and nothing physical to hold like a big, beautiful brick of gold, the crypto market is heavily affected by how investors feel at any given time.

News can become a snowballing effect. Positive buzz can send a coin soaring, but negative stories create a crash. Even a sliver of bad news, legitimate or not, can be the match that lights the fuse of significant volatility with no way of stopping itself, until it has run its course[1].

The value of cryptocurrencies, it seems, is largely determined by the emotions of the speculators (average age 38) who play in that space, often fueled by social media. To the latter point, Joe writes about Tesla founder Elon Musk: “Bitcoin prices have moved as much as 15% after a Musk tweet. Dogecoin increased 30% in May after Musk tweeted about it.” As of 9/30/21, Tesla owned $1.83 Billion of so-called “digital assets.”[2]  (In the fine print of Tesla’s latest SEC Form 10-Q, it says “digital assets may be subject to volatile market prices, which may be unfavorable at the times when we may want or need to liquidate them.” Yes, especially when the richest person on Earth tweets about them).

What is the difference between speculating and investing? In contrast to cryptocurrencies, traditional investments like stocks, bonds, or real estate have attributes that make them susceptible to rational analysis – specifically, future cash flows that accrue to the owner. Investors can estimate the intrinsic value of a stock, bond, or real estate by discounting those future cash flows back to the present at a discount rate that reflects the degree of uncertainty of those future cash flows.

Discounted cash flow (DCF) analysis is based on the concept of the time-value-of-money, that a dollar received in the future is worth less to you than a dollar held today. Why might that be? Uncertainty. For example, the future purchasing power of that dollar will be less than today’s because of inflation. If annual inflation is 5%, what $100 would buy today in goods and services will only buy $95 worth a year from now. An extreme example of that future uncertainty would be lending $100 to your less-than-ambitious brother-in-law. In that case, the present value of that future cash flow is zero.

In theory, the discount rate incorporates three components: the risk-free interest rate plus inflation plus an additional amount to represent the risk of not receiving what you expected. Valuing a bond is the best way to illustrate this. Bonds are debt instruments issued by corporations or government entities that pay a contractual amount of interest periodically and a final payment of principal at maturity. Owning a bond is the same as lending money to the issuer, who is on the hook to repay that loan to you with interest.

Suppose you want to buy a $1,000 par bond issued by Apple, Inc. (rated AA+ by Standard & Poor’s) which pays interest of $20 per year and matures in 10 years at par value. Assume that the risk-free rate is 0.5% and inflation is expected to be 2.5% and you add 0.5% to compensate yourself for the risk that Apple might default on its legal obligation to pay you interest and principal when due every year for ten years. The yield-to-maturity (YTM or discount rate) is therefore 3.5%.  This is the annual return on investment that you can expect to receive from owning the bond until it matures in ten years at $1,000. The question is, what price should you pay to own it? $1,000?

I’ll spare you the DCF math, but the price you should pay for the bond is $875.25. This price is identical to the present value of ten $20 annual interest payments plus the maturity value of $1,000 ten years from now, all discounted back to the present at a rate of 3.5%. Unlike cryptocurrencies, you can see that there is virtually no emotion involved in DCF calculations.

Now, because you’ve stayed with me this far (thank you), let’s add another aspect to DCF analysis: the farther out into the future that cash flows are, the less they are worth to you now. Let’s change just one variable, the maturity date, in our Apple bond example, to 40 years instead of ten years. Assuming the same 3.5% yield-to-maturity, the same $1,000 maturity value and the same $20 annual interest payment, the price falls by almost $200 to $679.67. Why? Because more of the interest payments and the maturity value are pushed further into the future.

One last thing to know about DCF (we’re almost to the finish line): what happens to the bond price when the yield-to-maturity suddenly rises? Suppose that immediately after you bought the 10-year Apple bond, the company’s credit rating is cut from AA+ to A+ overnight, due to some financial problems at the company. Potential investors in Apple bonds now perceive it to be riskier, and they double the risk compensation embedded in the discount rate from 0.5% to 1%. Now the new YTM is 4.0%. What does that do to the price of your ten-year Apple bond? It falls to $837.78, causing a paper loss of $37.47, due solely to a change in the perceived riskiness of the bond issuer.

Of course, the YTM can also rise for two other reasons: interest rates increase or expected inflation increases. Anything that causes the discount rate (YTM) to rise (or fall) will decrease (or increase) the price of the bond. There is an inverse relationship between interest rates and bond prices.

How does DCF apply to stock prices? For that, you will have to wait for Part II of the Market Observer.
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