My understanding is for REITs the distributions attributable to depreciation lower the stock holder’s basis, just as with a private property-level investment, without the ability to shelter gains upon disposition via 1031 exchange. I could definitely be wrong and I’m obviously not a tax expert.
I refuse to believe it.
Yeah, that’s all correct, but it’s not correct to say that REIT investors don’t get the benefit of depreciation to shelter cash flow–they do.
I’m not familiar with discount rate in this context, which is getting me stuck every time I read this post. Can you break it down for me a bit?
Assume I’m intelligent, but that my knowledge of terminology is severely lacking.
OK so here’s where I have a problem with this and/or just get confused. I may not know what I’m talking about so let me know if I’m wrong.
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Academically speaking, interest rates being low causes stock valuations to go higher. This is true mathematically because it changes valuations as above, and in practice because wealth basically has to be parked somewhere and if interest rates are low, it isn’t going to bonds.
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In real life right now, interest rates are 0 to 0.25, this putting this dynamic into play.
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However, rates shouldn’t necessarily be this low and it’s a somewhat politicized thing to keep the markets up for Trump, right?
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Regardless of #3, these rates should likely be higher and likely will be higher in the next few years.
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So if taking the rate back to, say, 1.0 to 1.25 is going to cut the value of these stocks significantly, because the P/E ratio should move back toward 15, and the current rate is basically arbitrary, doesn’t that mean we’re in a Fed-induced bubble?
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If we’re looking forward ~5 years in these stock valuations, shouldn’t we be factoring in the likelihood of a future Fed rate increase into the valuation?
I guess another way to put it, suppose AAPL should gain 8% per year in value and the Fed rate should average 0.75% in that stretch. That’s about a 43% increase in five years for AAPL. Cutting the Fed rate to 0 for a year, then working it back toward 1.5 would make the stock shoot up in year one and ease back down over time, but doesn’t this mean the market was irrational up front? (Or expected rates to permanently be near 0.)
Last but not least, in fact maybe most importantly, doesn’t the rate cut cause the valuation to go up in part because cheap/free money being available in the economy means increased opportunities to expand and grow companies? Like if they can borrow for free, they can take on investments with a lower ROI and still turn more profit. But isn’t there a limit to this? The opportunities to expand still have to be there.
I guess the flip side is that if a company is at an extremely low risk of going out of business, investors should be willing to pay more for it in terms of P/E ratios in comparison to other investment opportunities with lower returns.
[Holy shit this got long. Bonus: I’m not even sure if I answered your questions!]
I’ll start with the basics, just to make sure we’re on the same page.
A fundamental concept in investing and finance is that a dollar received in the future is worth less than a dollar in hand right now. What you’re doing when you buy a stock is buying a share of future cash flows in exchange for money right now. So when you’re valuing shares of a firm, you have to answer the following questions:
- How much will that company generate in cash flow for its owners?
- When will that cash flow be distributed to its owners?
- At what rate should that cash flow be “discounted”?
That last question is asking, “What’s my price of money for an asset of this risk (r%), such that I’m indifferent between (a) having $1 right now and (b) having $1*(1+r%) after investing that $1 in this risky asset?”. The discount rate is the answer to that question - r%.
This is easy to understand with a risk-free bank account. Suppose you have a savings account that pays a fixed 5% rate of interest. And, magically, you can also borrow however much you want from this bank at 5%. In that world, you are completely indifferent between (a) having $100 right now and (b) having $105 a year from now, because those two things are easily convertible into the other:
- If you have $100 in hand, you can convert it into future $105 by investing at the 5% rate.
- If you have $105 arriving in the future, you can convert it into $100 now by borrowing at the 5% rate and using the anticipated $105 payment to repay the debt.
Because those two outcomes are easily convertible into the other, they are economically equivalent. And that economic equivalence happens at the “discount rate” of 5%. In this case, we’re effectively talking about a risk-free rate of interest - because of government insurance, if you invest $100 in the bank, you will be guaranteed the 5% rate of return (or $105).
With that knowledge, you can now value a simple government bond with a face value of $105 that matures in one year. The value of that future $105 is equal to $105/(1+r), or $100. (The value of $1 of future payment is equal to 1/((1+r%)^N), where r% is your periodic rate and N is the number of periods in the future that the payment will occur.)
Now, for an investor, this risk-free discount rate is basically the minimum rate that they would require in order to invest in any asset. If you have an available 5% return risk-free, you would never accept a lower rate of return to invest in anything. And if you’re talking about risky assets, like stocks, you would require much more than 5% to invest in those stocks. That extra amount is the risk premium. The discount rate for a stock will be the combination of your risk-free rate and the required risk premium.
Back to those 3 questions:
- How much will that company generate in cash flow for its owners?
- When will that cash flow be distributed to its owners?
- At what rate should that cash flow be “discounted”?
Suppose you knew a firm would generate $100 in cash flows in the current year, and that amount would grow by 3% per year forever. How much is that firm worth? It depends on what your discount rate is. Some things to know about discount rates:
- Discount rates are asset dependent - you should require a higher discount rate investing in a company’s stock than you would need to invest in a AAA bond.
- Discount rates for stocks consist of a risk-free component and a premium for bearing risk. Historically, the equity risk premium has been in the 5% range in the U.S.
- Using a higher discount rate leads to a lower estimated current value for a constant amount of future cash flows. That’s because high discount rates make those future dollars less valuable right now. Similarly, using a low discount rate leads to a higher estimated current value for the same future cash flows.
- If you are correct in estimating how much (and when) the company will earn in future cash flows, your estimated value of the stock will grow at exactly your discount rate, REGARDLESS OF THE GROWTH RATE OF THE COMPANY. (I’ll revisit this point later, because it refers to a comment you made later on.)
So you’ve got this stock that’s scheduled to generate $100 in cash flows this year, with that amount growing by 3% each year. Let’s say that your discount rate is 10%. The value of those future cash flows happens to be = $100/(10% - 3%) = $1,429. (That’s called the Gordon Growth Model.) So the appropriate Price/Earnings ratio would be 14.29.
Now, you don’t have to take my word for it - you can calculate the present value of each year’s cash flow and sum them all up to get the value of the overall stream of cash flows. The first 5 years would look like this:
The present value of those first five years worth of cash flows is $445.74. But if you run that stream long enough, you’ll get a present value of future cash flows equal to the $1,429 that the Gordon Growth model gives you.
What happens if interest rates go down? Well, your risk free rate has gone down because you can no longer earn 5% just by sticking money in an insured savings account. That number is closer to 1% now. So that’s going to change how much return you can demand for owning stocks. You’ll still require the risk premium, but if the risk free rate has declined from 5% to 1%, then your overall discount rate has probably gone down from 10% to 6%. Now, that very same stream of future cash flows is worth much more than $1,429. In fact, it’s worth $3,333, for a P/E ratio of 33.3.
IMPORTANT: The following two things are simultaneously true, even if they might appear contradictory:
- The appropriate P/E ratio of the stock has increased from 14.29 to 33.3. There’s nothing bubblicious about it - under a lower discount rate environment (stemming from the lower risk-free rate), stocks and other assets really are worth more.
- The expected rate of return that you would earn goes down. Rather than earning 10% per year, you can now expect to earn 6% per year.
(Side note: This is most of the dumb idea behind Dow 36,000. "Stocks aren’t as risky as previously believed. Therefore, investors should be willing to accept a ~0 risk premium for owning stocks. Plugging in a ~0 risk premium drops your discount rate from around 10% to around 5%. If we assume a 3% growth rate, that means that P/E ratios shouldn’t be 14.3 (1/(10%-3%)). Instead, they should be 50 (1/(5%-3%)). That’s technically true, but the natural implication is that if investors drop their required rates of return so that prices jump up, those same investors should expect to earn that substantially lower discount rate going forward, rather than the 8-10% returns investors have historically earned.)
OK, IS ANYONE STILL READING THIS? IF SO, WHY?
Yes, investing is a game of opportunity costs. Just like a poker player looks for the best available table, an investor looks for the best risk-adjusted rate of return. If rates of return on risk-free assets drop, then investors will find risky assets relatively more attractive and be willing to pay higher prices for them, until the implied rate of return in those risky assets is appropriate relative to the new lower risk-free rates.
No. Rates are just a market outcome kind of reflecting investors’ patience for money. Here, you’re getting into the conversation about what the Federal Reserve should do in . The basic idea is that they have two goals:
- maximizing long-term employment (and, correspondingly, economic output)
- achieve stable, and moderate, inflation
Low rates are good for increasing employment and economic output, but also run the risk of inflation. Over the past 10 years, the Federal Reserve (imo) has very clearly not been aggressive enough in lowering rates - we should have been willing to bear the risk of inflation for more employment/economic output. There’s no reason to believe that current rates are “too low” or are somehow being weaponized to favor Trump. There’s also no way of knowing how long these historically-low rates are going to persist. If rates are going to stay at these levels for the next 10-20 years, stocks are a good buy right now. If rates are going to return to their historical levels in the next few years, they’re probably overvalued right now.
I’m skeptical that rates are going to return to historical levels any time soon. That’s because:
- Some bank was willing to lend me about $400k at a fixed rate of 2.625% for the next 30 years. That’s absolutely insane if you think there’s any risk of rates going up.
- Expected inflation based on 10-year TIPS is roughly 1.7% per year.
I’m not sure I understand the question. I think my answer is no. I don’t think the current rate is arbitrary and, as above, I don’t think there’s a good reason to believe interest rates are going to jump back up in the near future. (That doesn’t mean that prices are permanently high - if investors get spooked, it’s obviously possible for them to sell their risky assets. Academics would say this is investors “increasing their required risk premium”, which sounds kind of dumb, but is consistent with thinking about appropriate P/E ratios in a mathematical way.)
Sure, if you knew for a fact that the Fed was going to be increasing rates in the next 5 years, you should incorporate that expectation in your discount rate. Problem is, market seems to be disagreeing with you. There’s a general expectation that the Fed has an inflation target of 2% per year. Current TIPS imply an expected inflation rate of only 1.7% per year. So it’s not obvious to me that a near-term increase is at all likely.
Ok, here’s where I think you’re making a conceptual error, thinking that a stock (AAPL) should gain 8% in value per year. This is the point of my long-winded answer from above - stock value should increase AT YOUR DISCOUNT RATE. If you believe AAPL is worth $120 right now, and you estimated that value using a 7% discount rate, then you are implicitly - logically - saying that you think AAPL should increase in value by 7% per year. You can’t separate the discount rate used for pricing from the expected growth in the value of the stock - they are one and the same.
Last but not least, in fact maybe most importantly, doesn’t the rate cut cause the valuation to go up in part because cheap/free money being available in the economy means increased opportunities to expand and grow companies? Like if they can borrow for free, they can take on investments with a lower ROI and still turn more profit. But isn’t there a limit to this? The opportunities to expand still have to be there.
I guess the flip side is that if a company is at an extremely low risk of going out of business, investors should be willing to pay more for it in terms of P/E ratios in comparison to other investment opportunities with lower returns.
The drop in discount rate could have two effects:
- Making a constant amount of future dollars worth more in present value terms. That’s what I was focusing on throughout this conversation - even if the entire economy remained unchanged in terms of operations and cash flows, the lower discount rate would make stocks worth more.
- Lower discount rates could allow firms to generate greater profits. Maybe a firm had an opportunity to invest in a project that is expected to earn 6%. That might not be worthwhile if they borrow at 5.5%, but it’s much more attractive/profitable if they can borrow at 2%.
How long can that go before opportunities run out and those excess dollars just end up chasing the same pool of assets? That’s what the Fed has to figure out, because that’s what leads to inflation. But, again, there doesn’t seem to be any evidence of that inflation on the horizon.
Thank you for coming to my TED talk.
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What do you mean by historical levels? Like 1-2%? Or did they used to be even higher?
But as the economy improves, shouldn’t inflation go up if rates are low, thus causing an increase in the rates?
So basically Trump was right about Fed rates? Whether because he understood it, his friends understood it, he guessed right, or he had a well-timed stopped clock moment…
Or to flip it around, Obama should have strong armed the Fed Chair into cutting rates?
OK I’m still having trouble with this. It almost sounds like you’re saying stocks go up because people want/expect them to. I thought it was a combination of their earnings per share (current and expected) and inflation. So when I say AAPL “should” go up 8% per year, which is just an arbitrary number for this discussion btw, I’m saying basically if we expect that to be their average yearly growth in earnings + inflation.
Now when you say it should increase at my discount rate, I assume that really means the market’s discount rate?
So AAPL is at $120 per share, with earnings of $3.29/share.
I see high yield interest rates at 0.80%, so if the accepted risk premium rate is 5%, our discount rate is 5.8% right?
So if earnings grew by 3% (we’re just guessing for purposes of the argument, right? ), we’d have $3.29/(5.8%-3%) = $117.50.
That’s basically where AAPL is set to open today, I assume your 3% figure is either based on EPS growth the last few years or projections for AAPL in particular?
So basically a really simplified summary of all of this is that broadly speaking the US stock market should, on average, grow at about 5% + High Yield Savings Interest Rates % per year?
When interest rates go down, our expected ROI goes down, but the value of stocks goes up anyway because they are more attractive than the alternative?
Ultimately the part that still kind of has my head spinning is:
- Economy crashes
- Fed rate is cut to 0.25%
- Stocks are worth more, all is well again
Like I get that the S&P 500 are all massive companies less impacted by the recession or even benefitting from it, and the fact that it’s market weighted means it’s driven by the largest ones even still, but this seems kind of like:
- Economy crashes
- ???
- TPMM
Like a rate cut is just a magical fix the economy button with no ramifications?
And even though these big companies benefit from cheap labor, low interest rates, and opportunities to expand market share, don’t they still need people to buy their shit?
How are they immune to the effects of 10-15% unemployment, tens of millions of people facing eviction, probably tens of millions more behind a month or two on rent/mortgage but not yet staring down eviction, etc.
Like maybe the list of benefits offset the 10% unemployment. But let’s say 15 million people are evicted/foreclosed on between now and the end of the year, which I think is probably a very low estimate. Let’s even say they are working and able to pay rent anew, but unable to pay the back rent. Again, seems optimistic.
Anyway even in that rosy (by 2020 standards) scenario, 15 million housing units just lost money for 3-6 months. Don’t REITs get wrecked? Don’t some go to zero? Doesn’t this impact the S&P? Even if the S&P fades it (not sure how many REITs are in it or how vulnerable they would be since they’d be large ones), doesn’t this trigger some sort of chain reaction?
Like I cannot comprehend how we can fade that level of economic disruption without some significant and broad pain for investors.
Also thanks for the in depth response, really appreciate it! Learning more about this is interesting, but also more confusing than it feels like it should be with my math/poker background. So it’s good to have a detailed explanation on stuff.
I’ll probably have to re-read your post a couple more times to really get it.
Looking BLOODY this morning so far
TSLA down 15% premarket.
Dow (and Weekend Wall Street) and S&P futures were mostly up all weekend too until overnight. Europe had a good day yesterday but they are busy giving that back today too.
lol tesla
S&P aint got time for that, instant 15% drop, efficient markets baby!
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meanwhile NKLA up 50% after news GM is buying a stake
they still haven’t made anything
Asked my 8 year old daughter if she knew what the stock market was. Her answer started with “it’s an app on your phone,” but was otherwise more or less correct.
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Get her investing her college fund she sounds like she could generate amazing gains in these crazy times.
I had 390 tsla puts that expired worthless Friday.
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Tesla has lost almost 2 Honda market caps so far today.
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Jesus, approaching 20% today.
Elon should do another split.
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Is there an equivalent “circuit breaker” type trading halt for individual stocks?
God I wish it went to 0
Apparently there is, but it’s hard to figure out what the rules are because they seem to vary based on the stock price and perhaps other factors.