2022 Recap: From A Valuation Perspective

Topics: Valuation, Discount Rates, Duration, Equity Risk Premiums, Risk-Free Rates

And That's A Wrap, Folks!

Happy New Year! May this new year bring you cheer and no more market fear. I trust that the changing of the year will encourage you to establish challenging goals, set healthy boundaries, and plan exciting adventures. Better do it soon, because you can only set goals this one time of year... Right??

Anyways, let me give you the same summary every other news source, newsletter, finance influencer, reporter, and investor has already told you several times:

2022: Inflation, rising interest rates, supply chain issues, Russia and Ukraine war, inflation, Covid is less of a thing than it was last year, bad year for markets, economic uncertainty going forward, and employment markets have almost been as tight as you and your homies. Oh, also, did I mention inflation?

Frankly, this isn't super helpful imo. It's good to be reminded of what happened, but does it really explain why markets (S&P 500 at least) fell by ~20%? It's a significant decrease, but what caused it? Why did valuations fall by so much? Instead of just telling everyone it's because of "market uncertainty", I decided to whip out python and excel to show you what happened... just from a valuation perspective. 

Yeah, Sometimes I Model... In Excel

The premise of valuation is based on discounting the cash flows of a security (including its terminal value) (whether stock, bond, or otherwise) by a discount rate to come up with a net present value. 

There are literally a million considerations at play here, but in its most basic form, this is what it looks form:

This framework is what investors use to value most financial securities. Again, it is aggressively more complex than this in the "real world", but the concept is accurate. If you want to talk about valuation, feel free to reach out - I'd talk about this stuff for hours (just ask anyone I went to school with haha). 

Hey There... Are You A Discount Rate? Because You're WACC. 

WACC = Weighted Average Cost of Capital. This is the most frequently utilized discount rate used to discount cash flows to their present value for equities. As the name indicates, it's just a weighted average between the cost of equity and the cost of debt. 

The cost of equity is derived using the capital asset pricing model (CAPM). 

The cost of debt is equal to the current after-tax yield-to-maturity (YTM). 

Once the two are derived, you take the equity financing (i.e. market cap for public companies) and the debt financing (i.e. price of outstanding debt) to create a weighted average. 

Here's the WACC formula

Ok, So What's The WACCs Present Value?

*This analysis does not account for preferred equity and is based on the U.S. S&P 500 only*

**There are many other factors that could be included in a discount rate, such as country-specific risk, company-specific risk, size premium, etc.**

This WACC number is an estimate for the discount rate of an average constituent of the S&P 500. As you can see, despite the weight of debt increasing for corporations due to falling equity prices (debt financing is frequently cheaper than equity financing), WACC rose due to higher costs of debt, increased risk-free rates, and a larger equity risk premium. 

Here's how I pulled all this together:

• Weight of debt and equity: I pulled in the market capitalizations and total debt for all companies in the S&P 500 from YE 2021 and YE 2022 (thank you python) and created a market-cap weighted average.

• Cost of Debt: I pulled YTMs for BBB-rated bonds from YE 2021 and YE 2022 (thank you koyfin). The majority of companies with rated debt are rated A or BBB (for a quick overview of credit ratings, check this out.

• Risk-Free Rate: The 10-YR Treasury is the most frequently used measure of a risk-free return (though it can vary depending on the investment). Again, thanks koyfin for making my pretty charts easy to create.

• Beta: It's N/A since we're looking at the market as a whole. Beta measures risk relative to the market, so the market's risk relative to itself would be 1.

• Equity Risk Premium: Kroll (FKA Duff & Phelps) publishes this, though it's an arbitrary number based on qualitative factors like market uncertainty, volatility, macroeconomic headwinds, etc.

What Difference Does It Make?

A big one. Back to our example, here's how this change in discount rates would affect a sample set of cash flows:

Huh... a decrease of 14.1%... interesting.

There's also a growing pool of research that is attempting to apply the fixed-income concept of duration and convexity to equities. Estimated Duration varies widely, but it's a conceptually fascinating discussion. Anyways, here's an estimate based on applying a convexity and duration figure to our WACC calculation:

Exit Empirical Research, Enter Actionable Insights

Without factoring in the estimated decrease in profits for the year, the change in discount rates alone due to higher interest rates (RFR and corporate debt) and higher equity risk premiums (due to investors demanding a higher return bc "economic uncertainty") justifies a material reduction in price for many assets (both equities and fixed income). 

"Okay Drake, your fancy charts and smart sounding words are cool and all, but why are my high-growth tech stonk bets WAY worse off than other stonks."

Oh... I'm glad you asked. 

Many of the stonks that have taken the biggest L are growth / technology stonks. Because they are invested in the future, they make money further out into the future relative to most other companies. In my terms: it's going to take a hot minute for them to spit out some healthy cash flow. In tech terms: they have a growth-oriented objective and are working on making the future happen. In finance terms: their cash flows have a long duration and they'll need to scale before they reach profitability. 

In numbers, let's take two examples: a "value" stonk with larger cash flows sooner and a "growth" stonk with larger cash flows later. 

Both have the same NPV, though their cash flows look quite different. Now if we reduce the discount rate to the 7.0% WACC of 2021, here's what we get:

Both stonks increased, but growth increased by ~13%, while value only increased by ~11%. 

Now when we increase the interest rate to the 11.0% in 2022, here's what happens:

The value stonk decreased ~3%, versus the growth stonk decreasing ~4%. Because the cash flows of growth stonks are further out in the future, they are aided more by cheaper financing, lower market risk, and stable conditions, though they are hurt more by higher financing costs, economic uncertainty, and more risk. This is, in a nutshell, why valuations for technology stonks and IPOs decreased more than value stonks, like energy and financials. 

There are many concepts and nuances at play here, but I wanted to share this to provide context surrounding why stonk prices for many innovative, growing companies are falling despite having solid historical financial performance. This is the methodology banks, investment funds, and other investors use when valuing companies; the math is hardly ever perfect in finance, but the framework and its implications are profound.

There are headwinds ahead, as the impacts of tightening monetary policy haven't really hit yet, plus inflation, supply chain issues, the Russian and Ukrainian war, and Tik Tok are still things. This past year challenged stonk prices, while this coming year will likely challenge the financial performance of those companies. 

In Conclusion...

• My proxy estimate for WACC among constituents of the S&P 500 increased from 7.0% in FY 2021 to 11.0% in FY 2022.

• Despite the weight of debt in capital structures increasing for most companies due to falling equity prices, discount rates increased due to higher interest rates and larger equity risk premiums.

• Technology stonk valuations fell more this last year due to the nature of their cash flows being further out in the future relative to other stonks.

As always, would love to connect! Please reach out if you have any thoughts or ideas (or just want to synergize).