Are equities cheap? An attempt to use DCFs to solve this question.

Global markets are trading at single forward PEs.

Even with a new recession potentially coming, the EPS downgrades will put the markets on say 13x, which is around the LT average for Europe.

On that basis, one should buy Equities and close one’s eyes.

Or so goes the argument.

The problem is that this is not necessarily accurate.

Asset prices are a discounting machine. They discount expected future cash flows at today’s cost of capital.

Therefore, it is all about the future cash flows and all about how those cash flows will be discounted in the future.

I am going to use a simple DCF model, and these are my hypotheses below:

-          5% growth until the 2% terminal growth period

-          Stable 10% margin

-          6% equity risk premium, 3% risk-free rate

-          A gearing level of 50% and a tax rate of 30%.

Let’s start with cash flows.

Cash flows should over the long term be close to profits. Profits usually grow as fast as nominal GDP over the long run.

Therefore, 2 items are on my mind. What will be the future GDP growth over the forecast period? How will profits evolve along this long term trend?

I am negative on the first part. Deleveraging implies slower growth because growth was borrowed from the future in the previous cycle. One could assume 1pp lower trend GDP growth.

Lower than expected growth has nearly has large an impact on the DCF than higher than expected growth. 1pp higher growth boosts valuation by 8% while 1pp lower growth decreases it by 7%.

One positive argument can be that with the non tradable sector retrenching (government, defence, etc), the tradable sector will play a bigger role and therefore corporate profits can outgrow GDP. This remains a mitigation factor though.

Now for the discount rate.

A key feature of the Japanese recession has been the transfer of leverage from the private to the public sector.

Hence, I can see gearing level falling to 0 over the next 10 years or even go negative, with cash rich companies but unwilling to compromise that status.

A falling gearing ratio from 50% to 0% makes the DCF valuation decrease by 26%!

Then taxation has a little impact. Even if the corporate tax rate was to halve, it will reduce valuation by 4% as the tax efficiency of borrowing would be reduced (this does not take into account higher FCF since they are taxed less, we work here on the discount rate). However, in a low gearing environment, this would play a minor role.  

The risk-free rate increase to 4% from 1% would devalue the value of cash flows by 10% while a Japanese style fall to 2% would boost valuation to 3%.

Finally, increasing the equity risk premium by 1pp (decreasing by 1pp) yields an extra 7% (removed 6%).

Therefore, if we are headed for a Japanese experience (lower growth, lower risk free rate, lower gearing), a DCF value would be around 10% lower.

Conclusion

I believe the market is broadly efficient and is seeing through the lower growth profile, assigning now a lower multiple to those earnings that will disappoint later.

Therefore, the market is not necessarily cheap as the single digit PE suggests lower growth ahead, for which the market wants to pay little.

Which investments should therefore do well? Low expectations stocks with resilient low growth profiles where growth will not be downgraded coupled with cash rich balance sheets (will not suffer as their discount rate is already their cost of equity) should see the least impact from the DCF downgrades.

At the moment, it looks like the oil majors fill this category: they have no growth expectations in them (after of course disappointing repeatedly in the last few years). They also have single digit PEs and gearing ratios around 15-25%.