The interest rate makes valuations swing, particularly for companies that have high growth rates on currently low earnings. Kind of obvious, but under-appreciated, I think, for startups.
Here’s the way you can value the stock of Apple, based on the present values of the cash flows you think Apple will generate (discounted cash flow):
Apple earned about 100bn last year, so you just need to estimate how that annual number will grow over time, and how you want to discount future earnings. The snapshot above shows 4% growth, and a discount rate of 9.8%. The discount rate being the key here. You are assuming any dollar you *don’t* put in Apple stock could earn 9.8% somewhere else, without any risk at all, and so a dollar that Apple promises you next year is only worth about $.92 today (since you could earn 9.8% on that $0.91 elsewhere and it would be $1.00 next year).
That discount rate goes up when interest rates go up, and though people mostly talk about the Fed rate or mortgage rates, there are other layers of lending products out there that also move in tandem with interest rates. Check out the Bank Prime Loan Rate in the US, which is 7.5% today. Corporate bonds in the US are actually around that too, and Emerging Market Corporate Bonds have been 10-12% lately, because they are more risky I guess. (More trends.)
The risk-free rate of return is actually a straight-up ingredient in calculating a discount rate (aka weighted average cost of capital), so higher rates make discount rate higher. And another one is stock volatility (aka beta), and lately the fluctuations in the stock markets and startup markets make that higher too.
In normal times, you’d say a public company like Apple had a 10% cost of capital and maybe startups would be 20% or higher.
Venture lenders were charging startups 8%+ when corporate bonds were 4% back in 2018; and lately, the venture lenders are charging 12%+ when corporate bonds are at 8%. So that’s kind of a ballpark ratio. (Cost of capital includes the cost of debt but also the cost of equity, which I won’t get into.)
So what’s a company worth?
If you mess with the discount rate only, in a calculator like this one, and with numbers for Apple, you can make Apple’s valuation swing wildly from 1 trillion to 2 trillion (where it is today) to 3 trillion (where it was nearing recently). Just move the discount rate from 7% to 11% to 16%.
Take a look at this sheet I made and play with the numbers on it, except this time for startups. A massively successful startup that makes cash flow earnings in just a couple of years, and grows phenomenally for years and years…in a high discount rate world, is worth not so much. That’s pretty much what happened to all these high-growth recent IPOs – they don’t show earnings for a few years (because of the growth), but in the more distant years where they do have earnings, the bite of a high discount rate devalues them.
If you play with your growth stage startups forecasts in that sheet, the discount rate can swing you from 200mm valuation to 2bn if you tinker with 7, 11, 16, 20%. (If you are a public company, don’t you think you’re closer to 11% than 24%, after all? Perhaps not.)
When people talk about a “taste” or a “sentiment” for stable earnings or traditional business models, I think they are foolishly ignoring the plain old math of returns. When rates are a higher, earlier income is better. Which is why traditional industries have fared better this last 18 months (the Dow isn’t down nearly as much as the Nasdaq.)
Which comes back to the startup valuations – at pre-seed, seed, series A – that founders care about. Fred Wilson put his view out yesterday that we should see valuations return to 2015 levels, where a seed round is around 10mm and an A round is around 20mm pre-money. That would be about half of where things were 18 months ago. Nasdaq finished 2015 around 5,000, and is around 10,000 today, but 15,000 a year ago. So Fred implies that the tech stock market is oversold.
On the other hand, Howard Marks seems to be saying the opposite, as he’s usually a bear.
If we think the tech stock market will come back up in the coming year or two, the main assumption driving it would have to be that the discount rate eases up. Having browsed lots of year-end bank forecasts, they mostly agree that inflation should stop next year, rate hikes should stop, and even if rates don’t get lowered, it means markets will start showing lower rates on bonds.
Lower rates, lower conflict.
The funny things about predictions, though, is that nobody predicted Russia-Ukraine last Jan 1st, nor did anybody predict China would spend the whole year in oblivion vacillating on Covid. So I suppose the real value of predictions getting some insight into a theory of what makes the world work, and using that model to understand new things as they happen. Here’s hoping that prediction is true.