Higher expected returns = Lower intrinsic value? (Vice versa)
What gives? Say we're in bad times (say a bear market). Equity risk premium is expected to spike because investors require a higher rate of return to compensate for the added risk (this is all their subjective expectations of course, objective market expected returns are a different story - leave that for now). So chucking this in the CAPM, the expected return on equities increases? Cost of equity defo increases. So this, what, discounts us to give us a lower intrinsic value on equities? What's going on?
I'm confused - The spiked ERP gives a higher expected return for equities. But that discount, gives a lower intrinsic value for stocks! Shouldn't higher expected return equal a higher intrinsic value? Seems counter-intuitive to me.
So now that we have higher expected returns but a lower DCF, do we invest or not?
This is vice versa for when we're in good times and ERP drops
I see the confusion. Let's say that you want to purchase a lemonade stand. The lemonade stand generates $100 a year into perpetuity. Your discount rate is 10%. The price that you would pay for the business is $1,000 (=$100/0.1). Now, let's say that the required rate of return increases from 10% to 15%. In order to generate the higher required rate of return, then you can only pay $667 for it (=$100/0.15).
Yes, yes, great example! That leads me to my next question:
The lemonade stand is originally worth $1000
It's a bear market so shit is riskier. I require a higher return. That means the intrinsic value of the lemonade stand becomes $667 (from $1000)?
But what would the market price of the lemonade stand be, the price we can observe floating on the exchange? Still $1000? Or does it jump to $667 (let's assume frictionless, fairly efficient markets here now for simplicity's sake, that's why it jumps). Because all investors' ERP rise, not just mine.
If for some reason the price doesn't jump to $667 (let's say due to underreaction), should I short the lemonade stand?
In any case, the framework is sort of trash! The model predicts higher expected returns, partly due to higher required return (risk will reward us with a premium). But it just cheats by making assets cheap right now, not more valuable in the future
If the market is efficient, then the price should adjust down from $1,000 to $667. If the price does not trade down to $667, then it is theoretically overvalued. That said, people generally don't believe that over-valuation is reason enough to short a name -- i.e., who is to say that this business is actually worth $667? But if you can combine this aspect with other fundamental reasons to short the name -- e.g., you find out that the family that generates half of the lemonade stand's sales is moving out of town -- then that could be a compelling reason to short the name.
You are confusing the mean of a conditional distribution for something else. The market never said the stand is worth $1000 outright. The market placed a $1000 valuation on the lemon stand conditional on a certain market environment (let’s say bull market). Now conditional on a bear market the lemon stand has a $667 valuation. This is precisely the point - you buy based on NPV of forward expected cash flows… which includes not just the magnitude of cash flow but also the discount assumption.
Your return is your compensation for taking the risk of allocating capital to a particular investment, because all capital outlays are inherently characterized by risk/uncertainty in an investing context. As the risk of said investment increases, you should require greater compensation via higher returns. Now connecting that back to your question on why price should decrease, if you agree that the value of an asset is the sum of the future cash flows it will produce, cash flows which are adjusted for the risk/uncertainty of receiving them, as the investment becomes riskier the cash flows become worth less, because we have a lower chance of actually receiving them (all else equal). So as you require greater compensation for taking greater risk, the risk-adjusted present value of the cash flows declines.
Said a third way, how much would you be willing to pay for a bet where I gave you 100% odds of receiving a dollar tomorrow? It is worth $1 to you to take that bet (provided you agree with the odds). How much would you be willing to pay for a bet where I gave you 50% chance of receiving a dollar tomorrow? That bet is now worth $0.50 as you have 50% chance of receiving $1 and 50% chance of receiving $0. As the odds of the bet become less certain, i.e. payout becomes riskier, the value of the bet decreases.
Think of return as your compensation for risk and the relationship becomes clearer. A higher return implies more risk, and a riskier bet is worth less than a more certain bet all else equal.
The key word you are mistaking is "expected" - its not higher expected returns, it is a higher required return. This higher required return (given that interest rates are higher, uncertainty is higher, risk higher, etc.), translates into the value of your ownership of potential future cash flow now being lower. That is why on one hand, it seems silly that growth stocks get hit when rates go up (wait a second, you're telling me this business is suddenly worth less just because of the discount rate? Nothing about this business changed!). Well the value of the business, like all assets, is predicated on future earnings potential into infinity - and now since risk free investments yield 4% instead of 0.25%, the potential - or value - of receiving $10 in 25 years from now is not worth as much. For growth stocks, all of that cash flow is heavily weighted 20 years from now instead of tomorrow (not always but you get the point).
I do agree that intuitively at first it seems ridiculous that if the business fundamentals may not have necessarily changed, it shouldn't be worth less suddenly, but the other conversation is that every $1 everywhere is a capital allocation and opportunity cost debate. The other side is at any point in time, a stock is the reflected average of what everyone is willing to pay for that ownership stream of cash flow into perpetuity - so small changes in things like what our required return rate / riskiness, and perception of the quality of the biz, can have an outsized impact. Good news is that longer term its a weighing machine for the actual results they deliver.
Your mistake is trusting CAPM as a solid risk/return framework
Think of "expected return" not as how much your investments are paying out, but as the bar against which you're comparing how much your investments are paying out.
And to continue the lemonade stand example, if all investors' ERPs rise, then all lemonade stands go from being worth $1,000 to $667. Because they're now all riskier. So yes, they do have lower intrinsic values.
Yesterday, you were expecting that the lemonade stand would have a few years of earning you some good money. Now the economy is shit, the lemonade stand might go bankrupt sooner than you thought, even if doesn't people aren't buying as much lemonade and now you're not pulling in as much cash that means you can't then go and invest that extra cash in some other cash-generating business, so on and so forth.
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