Head-scratching has resulted from asset valuation increases in the face of a rocky economy. On the surface, the increasing value of companies or properties does not make sense. Dubious prices are due to the uncertainty about our future; many say there must be some bubble. The purpose of this post is to explain such exuberance as lowering interest rates may be leading to exponentially higher asset values.

## P/E Ratios

**The most common way to value a public stock is through a formula called P/E Ratio:**

**P/E Ratio = Price / Earnings**

Rearranged,

Price = P/E Ratio X Earnings

Let’s say that a company makes $100,000 per year in earnings. Historically, the P/E Ratio for similar companies is 20. At what price should an investor value the company?

Price = P/E Ratio X Earnings

Price = 20 X $100,000

Price = $2,000,000

The entire company is worth $2MM.

The company has 10,000 shares. There are a few ways to find the per-share price. In one way the earnings are divided by the number of shares outstanding. ($100K / 10,000 shares) which equals $10 per share. Running through the same equation, 20 X $10 = a $200 price per share. In another simpler way, the answer found as the $2MM total company value is divided by 10,000.

The key variable in the equation is the P/E ratio. Flipped, the formula is an **Earnings Yield (Earnings / Price) which illustrates how much the company earns annually as compared to its value.** In the above equation, a P/E ratio of 20 is equal to an Earnings Yield of 1/20 or 5%.

An investment making 5% annually is more comparable to returns of other investments, as opposed to the P/E ratio. As a comparison, Money Market rates were around 2% in the 00s, at a time when Earnings Yields for public stocks were around 5%. An investor could get a steady, risk-free 2% return on their money or they could get 5% from a more risky public stock investment.

As interest rates for federal treasury bills (and accordingly Money Market Accounts) fluctuate, so do return requirements for other investment alternatives. When investors put more or less of their money into public stocks, the law of supply and demand will move prices of assets up or down and therefore yields.

For instance, if interest rates increased such that a Money Market account would yield a 6% return, then investors would place their money into this safe investment as opposed to getting a riskier and smaller return on a public stock yielding a 5% annual return. In that scenario, the investor may want to increase their threshold to invest in a public company to a 10% return. Such a return would be the equivalent of a 10 P/E Ratio.

Similarly, if a Money Market account were to have a diminished return of 1%, then investors would rather put their money into public stocks at a 5% return and they accordingly iinvest more money into public stocks. The 5% return in the base-case scenario, however shares of a stock may be bid up so that investors are really receiving a return of 3%, or a P/E ratio of 33.

The chart below compares the scenarios mentioned, highlighting what happens to the price of a share of stock as a result.

Money Market | Earnings Per Share | Return Requirement | P/E Ratio | Price of Share |

1% | $100 | 3% | 33 | $3,333 |

2% | $100 | 5% | 20 | $2,000 |

5% | $100 | 10% | 10 | $1,000 |

You can see that there can be wild swings in the value of assets as a result of what seems to be minor adjustments in interest rates.

## Mortgage Rates

Using the above logic, the asset price appreciation caused by interest rate changes also has an impact on home prices. Here is an illustration of how a family, with the same monthly housing budget, can afford to pay different prices for a house depending on fluctuations of mortgage rates.

The Henderson Family has a take-home pay of $6,000 per month. They decide to put 25% of their pay towards a 30-Year mortgage payment. For simplicity, we will remove taxes and insurance.

The chart below shows three scenarios of mortgage rates using 4%, 6%, and 8%. The amount of loan that the Hendersons can qualify for swings $110K (more than 50%) simply due to interest rate fluctuation.

Payment | Mortgage Rate | Loan Value | Home Price |

$1,500 | 4% | $314,192 | $392,740 |

$1,500 | 6% | $250,187 | $312,734 |

$1,500 | 8% | $204,425 | $255,532 |

The primary governor of home price in this analysis is the down payment, and not the loan value. If the Hendersons want to put a conservative 20% down for their home purchase, they will have to put $51k down in the 8% interest rate scenario but $79K down in the 4% scenario.

The Hendersons need to have that money saved in order to conservatively qualify for the increased home price.

## Spread vs. Premium

**When factoring an appropriate Earnings Yield for a certain investment, we assess how risky it is.**The chart below shows an example of the return requirements for various types of investments (though the return thresholds shown are not current).

You can see that what is considered risk-free, Money-Market accounts in this chart, sets the floor for investment returns. The floor is the minimum amount of return a rational investor could be expected to earn. As we go up the slope of possible investments, the riskier the investment, the more that an investor will require their return to be. **The difference between the risk-free rate and the return of a certain investment is considered the “spread.” **For a somewhat risky Large-Cap stock return, which is 10% in this chart (shown as S&P Stocks), the spread is 6% when compared to a risk-free return of 4% that a Money-Market account would give you. A Real Estate deal would bring a spread of 11% as it is even riskier than Large-Cap stocks.

**What happens to spreads and capitalization rates when risk-free interest rates fluctuate?**

Let’s say that a Money-Market account went to 14% as opposed to the 4% shown in the chart. This scenario is not outlandish as worse happened in the early 80s. Would the spread for Large-Cap stocks still be 6% (such that stock returns expected by investors are now 20%)? It is possible. An alternative way of comparing the investments is to maintain a ratio premium. In the base-case 4% Money-Market scenario, an investor was given a premium of 150% to put their money in a riskier asset class of Large-Cap stocks as compared to a risk-free Money-Market account. In this increased interest rate environment, an investor would need a 35% return in order to get the same premium! A return of 35% may be absurd to demand but when the alternative is a 14% return for doing nothing, investors expecting outrageous yield to invest their money in riskier assets seems justified, at a time where there is likely great uncertainty.

Let’s look at interest rates when they swing in the other direction. If Money-Market accounts fall to a return of 0.5%, as it is the case today, then investors would need a 1.25% return to get a similar premium as the base-case. A 1.25% return for a risky investment like Large-Cap stocks seems ridiculous but, if an investor cannot get any risk-free return on his capital, then they may be a part of a crowd of investors clamoring to get any return. If so, they will bid the price up for various assets (thereby pushing down returns). This chase for investment returns is called “seeking yield.” Alternatively, maintaining a 6% spread by expecting returns of 6.5% in a low interest rate environment seems equally preposterous as it was in the much higher interest rate scenario.

**As the rate of return is diminished, and the earnings of an asset stays the same, the price of the asset must go up. As return requirements for investments approach zero, the asset prices ***exponentially*** increase. On the other hand, as an interest rate increases, the pressure on pricing to decrease is impacted but to a lesser degree. **

## Capitalization Rates

In commercial real estate, which is my sandbox, we use the “Capitalization Rate” to value properties. This term is the same as “Earnings Yield.” The formula for Capitalization Rate is Income / Value, which is Earnings / Price using slightly different terminology.

When introducing team members to underwriting, we typically solve for our own spread. On real estate development deals, a spread is calculated between the Development Yield and its Capitalization Rate. Lets say that a prospective project will earn $1MM in its first full year of operation. As a stabilized asset, an investor can expect the asset to earn a Capitalization Rate of 8% on their purchase price of the asset. The property, once completed, would be worth $12.5MM using those inputs.

Capitalization Rate = Income / Price

8% = $1MM / Price

Price = $1MM / 8%

Price = $12.5MM

As we would be looking to develop the property, we will want a profit margin, which is a spread from its Capitalization Rate. Typically, that spread is around 2% to justify the additional risk inherent in developing an asset vs an already built, stabilized asset. We will need the asset to yield 10%, or be developed for a cost of $10.0MM.

Development Yield = Income / Cost

10% = $1MM / Cost

Cost = $1MM / 10%

Cost = $10MM

In order for the development to be lucrative enough to take on the added risk of developing it, the $2.5MM difference gives the developer an entrepreneurial profit and compensates them for the time and effort they are taking completing the project.

Let’s say that times have changed (as they have recently) and the stabilized asset is now priced to meet an Capitalization Rate of 4%, meaning the property once developed will be worth $25MM.

Capitalization Rate = Income / Price

4% = $1MM / Price

Price = $1MM / 4%

Price = $25.0MM

As a developer, the flawed thinking would follow that a 2% spread should be applied to the new capitalization rate, so the all-in development cost would be $16.7MM to meet a 6% Development Yield.

Development Yield = Income / Cost

6% = $1MM / Cost

Cost = $1MM / 6%

Cost = $16.7MM

The problem is that the ratio between the Capitalization Rate and Development Yield is out of whack compared to the original scenario (8% Capitalization Rate for a stabilized asset); entrepreneurial profit would be $8.3MM. In this new scenario, the spread should be only 1% to keep the ratio consistent. As an all-in Development Yield of 5%, the total cost would be $20MM.

Development Yield = Income / Cost

5% = $1MM / Cost

Cost = $1MM / 5%

Cost = $20MM

The new cost for development is $3.3MM higher than before but still preserves a healthy $5MM of entrepreneurial profit compared to its finished stabilized value. The developer should feel comfortable willing to pay more using this logic if they want to pursue the opportunity.

## Negative Interest Rates

As interest rates approach zero, we have seen that there is pressure on asset prices to sky-rocket. Simply look at the values we have already discussed. With lower interest rates, all investments become more expensive, including public stock values. This ballooning of pricing is not due to the individual company performance but rather the more global interest rate picture.

**As a cautionary thought, what happens when interest rates turn substantially negative, as in -2%?**

Banks are going to be reluctant to lend money at negative savings rates. No one will want a Money Market fund at -2% as they would be losing money. Subsequently, all of the banks’ deposits would dry up. As a result, **banks will be one major group that would prevent that negative interest rate world from occurring.**

Another force would be that investors would be reluctant to pay the astronomical prices for assets, only to get a tiny percentage return; a scene that would logically be the case in a negative interest rate world. **Investors can be expected to rationally put a ceiling on asset prices (which means a floor on return thresholds).**

**Without market participants balancing these investment return requirements, a world with substantially negative interest rates would be one where the wheels of the economy would fall off. **In that case, no one would know how to price investments. Even super-risky investments would have paltry returns.

## High Values, Low Returns

The current environment is exposing a dichotomy between Main Street and Wall Street. While incomes and spending are suffering globally as a result of pandemic lockdowns and economic restrictions, asset values are soaring. There are numerous reasons that can be pointed to this discrepancy, but the above focuses on the unprecedented low interest rate environment. Investors still need a vehicle to place their capital.

In light of interest rates and their impact on investment types, **market participants are seeking yield from anywhere. Accordingly, they are deploying their cash to limited assets, which is pushing up asset prices. Meanwhile, investors are accepting lower returns for taking on such risk.**