Skip to main content

The Globe and Mail

A critical idea in valuing stocks is being made obsolete by low rates

An investor looks at an electronic board showing stock information at a brokerage house in Shanghai, China June 23.

© Aly Song / Reuters

Years of ultra-low borrowing costs means that many governments - and even corporates - are no longer paying much for time, throwing into jeopardy what Sanford C. Bernstein considers to be the "heart" of financial analysis.

Discounted cash flow modelling, or DCF, is a method of arriving at a fundamentally-driven net present value for companies based on the estimated evolution of their cash flows over the life of their operations. Future earnings potential is "discounted" in light of the presumption that receiving a dollar today is usually more valuable than a dollar tomorrow; in addition, because of the cost and risk associated with financing the creation of those cash flows.

The new normal of low interest rates means that an increasingly small amount of the net present value of a company is determined by its estimated financial performance in the near-term, however, with longer-term forecasts growing in importance even as they become more uncertain because of the unknown path of future interest rates and cash flows. This poses an acute problem for companies attempting to assess the merits of given investment project, or, even more so, a major acquisition as well as analysts seeking to gauge their worth.

Story continues below advertisement

"The problem is that they were invented and historically used in a world where risk free rates averaged 5 per cent or more," writes a Bernstein team led by Head of Global Quantitative and European Equity Strategy Inigo Fraser-Jenkins. "In a world where the risk free rate is close to zero then the errors in such models explode."

Analysts can be expected to offer increasingly inaccurate forecasts about a company's ability to generate cash flows the longer their projection horizon extends, the strategist reasons.

So when the discount rate collapses, the overwhelming majority of the company's valuation is based on how its cash flow generation will evolve more than 10 years down the road, which magnifies an issue inherent in DCF analysis.

"Our case is that any framework that ascribes anything approaching 90 per cent of current value to cash flows that are necessarily unknowable far in the future has to be flawed," Mr. Fraser-Jenkins writes. "We have never had discount rates at such low levels as we have today and hence have never had this problem before."

Their research complements the recent work of St. Louis Fed President James Bullard, who elected to forego publishing a long-term estimate for the federal funds rate, citing the possibility of a regime change that could radically alter potential neutral level of the policy rate. It also mimics complaints that have echoed in the corporate bond world, where analysts have long complained that low interest rates have wrought havoc on their default models .

Bernstein, which has lately been waging war on many traditional financial pillars , doesn't think it's time to toss DCF modellng into the rubbish bin.

Importantly, Mr. Fraser-Jenkins notes that inasmuch as this analysis is being used to assess the investment thesis for one equity relative to another, the major issue surrounding the impossibility of forecasting a company's longer-term prospects washes out.

Story continues below advertisement

"Use DCFs, as we have little alternative," he concludes. But "any move lower in discount rates would, we suggest, cause a significant methodological problem for financial analysis."

Report an error
About the Author
Investing reporter

Luke Kawa joined the Globe and Mail as an investing reporter in 2014. He is a graduate of St. John’s University with a B.S. in Economics. Previously, he was the editor of Business in Canada and a contributor to Maclean’s. He has also written for Business Insider’s Money Game and Clusterstock verticals. More


The Globe invites you to share your views. Please stay on topic and be respectful to everyone. For more information on our commenting policies and how our community-based moderation works, please read our Community Guidelines and our Terms and Conditions.

We’ve made some technical updates to our commenting software. If you are experiencing any issues posting comments, simply log out and log back in.

Discussion loading… ✨