And worst of all, patient

Changes in interest rates by the RBI, as seen in Part II, have an effect on stock valuations and the economy. It affects valuations directly (by increasing the risk-free rate of return) and indirectly (by changing the investor's expectations of future earnings growth). What creates the need to hike interest rates? curbing inflation is the dominant reason.

Cheap money

Inflation is, simply, too much money chasing too few goods. In times of low interest rates and high economic growth, the economy is awash with money. The production of goods, however, does not keep up leading to a mismatch between supply and demand. With all that money, people are willing to pay more for the same thing. Rather than things getting more expensive, it helps to look at inflation as money getting cheaper. Put another way, inflation reduces the purchasing power of money.

The real rate of return

How much the rupees you have can buy is more important than how many rupees you have. Nominal return is what you think you're gaining on your investment. If you made an investment at Rs.100 which is worth Rs.120 after one year, your nominal rate of return is 20%. The real rate of return is the return on an investment after inflation and taxes (if any). If inflation was at 5%, your real rate of return is 15% in the above example. A positive real return indicates that you have greater purchasing power than when you started. When your nominal rate of return is less than inflation, you're losing real money. Your money now will get you less than what it used to.

Inflation and stock valuations

It seems logical to postulate that inflation should leave a company's earnings (and therefore, its valuation) unchanged. After all, inflation of x% would cause an increase of x% of prices of products. This, in turn, should increase the nominal earnings by x%, leaving the company's earnings unchanged in real terms. The key assumption here is, of course, that a company can increase the price of its products at the same rate as inflation. The ability to pass on increased costs to the customer is not that easy, especially in competitive industries that are volume-driven. The effect of inflation on the profitability and growth of a business is highly dependent on the business itself. Companies that can pass on their increased costs to customers have the upper hand in times of increased inflation.

Forget inflation's secondary effects for the moment. Should inflation, by itself, cause investors to look for returns marked up the increased rate of inflation? There should be a change in expected nominal return to preserve the investor's real rate of return. If a company can pass on costs to customers, its valuation should remain unchanged as the nominal growth rate has kept up with inflation. If the company cannot increase nominal growth in line with inflation, its valuation should fall to reflect the decreased real return rate.

There is another effect at work during inflation. Since fixed-income instruments have no protection against inflation, the fixed payout of a bond is worth less in real terms with each sucessive year. There is a belief that stocks are an effective hedge against inflation and the increased demand for stocks would increase stock valuations. As noted before, an individual company may or may not outrun inflation. Second, too much inflation causes a cycle of lower consumer spending and lower economic growth called stagflation. Stocks are not a guaranteed hedge against inflation but they work at most times. Guaranteed hedges are inflation-indexed bonds that change their yield to reflect inflation.

Increasing inflation will also lead to rising interest rates. The RBI, to keep inflation under check, will increase interest rates. Why? rising interest rates makes money more expensive mirroring the rise in prices. Then, as explained in Part II, stock valuations will fall.

GDP and corporate profits

GDP or Gross Domestic Product is the total value of final goods produced in a country in one year. There are two kinds of GDP. Nominal GDP is the monetary value of final goods produced. Real GDP is nominal GDP minus inflation. Growth in GDP is the subject of much speculation as it provides information of where the economy is heading: are we slowing or accelerating? Besides, GDP growth rate provides the limiting factor of corporate profit growth. One company cannot grow faster than the economy does forever. Corporate profits is one component of GDP. Assuming a constant corporate-profit to GDP ratio, it could be said that average corporate profits would grow at the same rate as nominal GDP. Economic data shows that corporate profits tends to a constant percentage of GDP. Note that this 'big-picture' view does not preclude sectors or companies growing faster than the economy for short lengths of time.

GDP and valuations

Nominal GDP growth, if used as the yardstick for growth for corporate profits, can be used to define if markets are overvalued. If the weighted P/E ratio of stock market indices anticipate a faster growth rate than the nominal GDP, they are going to be disappointed. But when it comes to individual companies, we face complications. How does a change in GDP growth affect company X in a quantitative manner? Some industries such as steel are closely linked to GDP and their growth can be more or less had from GDP growth. For some other companies, you can use a slightly different model. First, find the source of revenue, its percentage of consumption expense and the trend in percentage change. For example, to link soft drinks to GDP, a very simple method would be:

1. Find out the expenditure on soft drinks as a percentage of household consumption
2. Find out if soft drinks is an increasing or decreasing percentage of household consumption
3. Project the future percentage of expenditure on soft drinks
   
4. multiply it by nominal GDP to get projected growth of the soft drink industry
   

As you can see, nominal GDP underlies earnings expectations. Revisions of GDP growth will affect anticipated earnings growth which,in turn, will change stock valuations.

History repeats itself

We have seen three important macro-economic variables (interest rates, inflation and GDP) and their effect on stock valuations. How do these three tie in together? consider an economic cycle that ties them all together with the market in cause-and-effect style:

1. Low interest rates
2. High GDP growth (cheap money, more spending)
3. Bull market (optimists unite!)
4. Increased money(excess liquidity)
5. Inflation rises ( more money, less goods)
6. High interest rates (money is now more expensive, courtesy the RBI)
7. Low corporate profits and growth (margin squeeze, less spending)
8. Bear market (people get out of stocks)
9. Interest rates lowered (stimulate economic growth)
10. Go back to 1.

From Part I, we see that the expected return on stocks is above that of the risk-free return rate by a margin called the equity risk premium (ERP). The equation is:

Return on stocks = risk-free return + equity risk premium

Technically, the ERP ought to be multiplied by a risk factor, beta, which we will assume to be 1 for now. An ERP of 7% on top of a risk-free return rate of 7% results in an expected 14% return rate on stocks. The above equation does not imply that the return rate on stocks will be 14%. Quite the opposite, it means: make sure the price you pay for the stock will get you a 14% return on your investment.

What's the risk-free rate?

The usual suspects of the investment universe are stocks, bonds and government securities. Of the three, the least risk lies with goverment securities ( 'No one ever got fired for buying too many G-Secs' and all that). A popular benchmark used for the risk-free rate is the yield to maturity (YTM) of 10-year Government of India bonds which is market-determined.

Below is the image of the so-called yield curve showing the YTM of GOI bonds of different maturities. Note that bonds with longer maturities have higher yields to compensate for interest rate risk (risk of rising interest rates causing a fall in the security's price).

At the bottom of this yield curve is the Reserve Bank of India's repo rate. The repo (repurchase) rate is the interest that the Reserve Bank of India (RBI) will pay banks for parking their excess funds with the RBI. By controlling this ultra-short-term rate, the RBI can control the entire yield curve. The RBI has more controllable rates (the reverse repo rate and the bank rate) which we won't get into. Since changes in these rates imply changes in other interest rates in the economy, it really doesn't make a difference which interest rate you mean. They're all changing. You can just say 'rising interest rates' and everyone nods.

The butterfly effect

Increasing interest rates means that investors now expect greater returns on their money when investing in stocks. Since nothing about the companies and their businesses have changed after the rate hike, the stock prices will have to fall to yield this higher return. Assume that company A was priced at Rs.100 with an expection of 15% growth. If the risk-free rate increases by 1%, the expected return will increase by 1% to 16%. This means company A's stock price will fall to ~Rs.94 to yield 16% growth.

Further, debt is costlier for companies after the interest rate hike and that hits the valuation of stocks yet again. The interest rate hike increases the interest that companies will pay on their loans. More of a company's earnings will now go toward servicing debt leading to depressed earnings.

It's never so bad that it can't get worse. Suddenly, everyone is paying increased interest on their loans (home loans, auto loans, what have you) leaving less discretionary income. Less income equals less spending equals less sales equals less earnings.

A fall in interest rates has the opposite effect: Money is cheap, people spend more and the economy grows. We, here in India, have seen this side for the past few years with falling interest rates stimulating economic growth and consumer spending.

It pays to pay attention

With such wide-ranging effects on the economy, it pays to pay attention to interest rates and the rationale behind their use by the RBI. Being that we're all long-term investors here, the trend of interest rates changes is more important than the current interest rate. That trend ought to be factored into your calculations when you look at your next stock.

Tech Tags: india stocks macroeconomics valuation stock market DCF discounted cash flow GDP inflation interest rates india stocks india investing indian stock market value investing

# posted by Aditya Ramachandran @ 3:10 AM 1 comments

Why should you,as an investor, worry if inflation is rampant? Why does CNBC have one-hour specials on whether the Finance Minister might have said that he might raise interest rates? Why does an expected 8% increase in GDP get mentioned everywhere (especially in blogs with weird titles)? Because they affect your choice of investment, the price you'd pay for that investment and the potential return on (and of) your investment.

Reason enough, I'd say, to look closer. Welcome to the world of macroeconomics, where numbers are large (millions, billions, trillions...) and percentages are small (1% ,5% ,7%...).

What determines stock prices?

The stock price reflects the present value of discounted future earnings of the stock. The oft-used analogy is this: If I say that I will pay you a rupee (or a dollar, if you prefer) every year for eternity from today, how much would you pay me for that privilege?

It depends (why are you not surprised ?!) on

1. How much riskier I am than Government securities (G-Secs) or T-Bills
   
2. How much you expect to be compensated for this risk of investing in me over government obligations
   

Given my unstable nature and the fact that I cannot crank up taxes to pay off my obligations, you would expect my rate of return to be greater than that of G-secs. The expected rate of return over risk-free securities is the risk premium. From then on, it's simple. By simple, I mean that there are online calculators to protect you from the math that follows.


Account for the future (with discounts)

We will use a model called the Discounted Cash Flow (DCF) model where the required rate of return is used to discount future rupees to arrive at their present value. The expected rate of return will be used as the discount rate. The running sum of discounted future rupees is the price you ought to pay to get the chosen rate of return. This is mathematically shown as follows for a yearly rupee stream (Note: Rupee(x) denotes present value of a rupee received x years from now):

Rupee (1) = (100% - discount%)¹ * 1;
Rupee (2) = (100% - discount%)² * 1;
.
.
.
Rupee (n) = (100% - discount%)ⁿ * 1;

Present Value = Price to Pay = Rupee (1) + Rupee(2) + ...+ Rupee(n) + ...


As you can see, the further you get into the future, the less a rupee then is worth now. Eventually, Rupee(x) is almost zero if x is big enough. This means that the present value will converge to a finite number as those almost-zeros far in the future are too small to affect the running sum very much.

Since we also expect most companies to grow, you can account for expected earnings growth by reducing the discount rate by the expected growth rate as shown:

Rupee(n) = (100% - (discount% - growth%))ⁿ * 1;

This is by far one of the simplest valuation methods that assumes ideal conditions but it will serve the purpose of demonstrating what lies beneath a stock's valuation. Some excellent reading material on DCF and other valuation methodologies can be found on moneychimp.


The future is not what it used to be

The price of a stock as valued above depends on:

1. expected earnings growth
2. required rate of return
3. rate of return on risk-free securities

Valuations are sensitive to changes of the above parameters. For example, take a company which is expected to grow earnings at a rate of 20% every year for 4 years and then stop growing. We decide that we want a return of 10% on our investment. With the DCF model, we'd pay at a P/E ratio of 20. Suppose, based on new information, we downgrade the growth to 15% for the next 4 years, the P/E changes from 20 to 16.

The perceived future changes all the time and that changes one or more of the assumptions built into a stock's valuation. This change, in turn, will necessarily be reflected in rise or fall of stock prices in line with the valuation change. In subsequent parts of this post, the effect of some macro-economic variables on stock valuations will be dealt with.

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Step 1: Don't

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It's raining IPOs here in India. A string of IPOs and the associated media blitz can hardly fail to affect the retail investor. Companies, once listed, immediately jump up in price showing an almost instantaneous profit. To most, it would seem that IPOs are one of the easiest (legal) ways to a quick buck on the market today. And they're right, but only if they're the ones doing the selling.


IPOs and bull markets

According to Benjamin Graham, the sign of the tail end of a bull market is this: IPOs of sub-standard companies at premium valuations. Bull markets are characterized by excessive optimism and high liquidity. In other words, people have a lot of money and are willing to pay a lot for companies since they see a bright future ahead. Can you think of a better environment to sell? The charter of any company is to maximise the amount of money received for its shares. If the company sees the time as ripe for selling, why would you think it's the right time to buy?

Pay the Price

This is an excerpt from the Basis for Issue Price from the Royal Orchid Hotels red herring prospectus where the company explains why you ought to pay what they are asking for. The choice of this company was slightly less than random. They're based here in Bangalore and, I confess, I like their buffet.

Price/Earnings (P/E)* ratio in relation to Issue Price of Rs. [•]
a. Based on year ended March 31, 2005 consolidated EPS of Rs. 6.36 - [•]
b. Based on weighted average consolidated EPS of Rs. 3.91 - [•]
c. Industry P/E**
i. Highest - 96.0
ii. Lowest – 3.8
iii. Industry Composite – 34.2
*would be calculated after discovery of the Issue Price through Book-building
** Capital Market Issue dated December 19, 2005 –January 1, 2006, Category - Hotels

The argument they make is that a P/E of 34.2 is fair for the industry and ought to be the minimum you should pay along with a premium for the growth potential of this company. The investor's line of thinking should instead be: The industry is already historically overvalued and, based on this company's short history of exponential growth and continuation of the same, I should pay more than I would for well-established firms even in the same industry.

There! makes it easier to say no, doesn't it?

Exponential growth, or else...

As with any other growth stock, investors expect the IPO company to just keep growing at the same pace. A slowdown in growth rate is enough to make the investors jittery and the stock price falls like a buttered brick. God help them if there is actually a fall in profits. If you think that's unlikely, consider these statistics based on a study of 452 IPOs:

1. 69% were afflicted by declining sales and earnings trends while only 14% showed improvement

2. Almost 80% achieved peak profit margins within four quarters before or after their offerings. SIXTY percent then slipped in profitability within two years of their IPO.

3. A quarterly earnings drop in the first four quarters after the IPO occurred in 58% of the companies. More than 75% had a decline within two years.

4. 1/3 of the companies had a sales decline within four quarters and 45% had a sales drop within two years.

5. 19% actually lost money in one of the first four quarters after the IPO.

6. 25% lost money throughout the two year period of the study.

Everyone wins (except you)

The company goes IPO on strength of growth for the past few years and when its sector is 'hot'. Thus, it is almost guaranteed to be over-valued. The underwriter of the IPO gets a ~7% commission of which 33% is profit. Any brokerage firm gets in on this action via transaction fees from participating retail investors. Given this, do you really expect any of these people to tell you not to buy into the IPO?