Archive for October, 2019

Low interest rates are bad for fundamental analysis

Monday, October 7th, 2019

Investors price an asset by predicting the free cash flows (FCF) that the asset generates. Even if you expect to sell the business at some point, if you commit to the decision rule that you never sell unless the returns from a sale are greater than that from the FCF, then the FCF analysis is all you need to proceed – you do not need to worry about what other people think the asset is worth. The asset is priced as if held to maturity.

Speculators price an asset without such a simplifying assumption. It’s just buy low and sell high. Speculators care intimately about what other people think an asset is worth. Speculation is a shorter-term activity because in the shorter term the net present value (NPV) of carry is small relative to that of the sales event.

Interest rates can change what it means to be short-term. When interest rates are low, the carry matters a lot less. When carry matters less, it is not possible to rely purely on FCF analysis, because the uncertainty in your predictions of what happens in ten years doesn’t get discounted away, and has material impact on the NPV estimate. We are all speculators now.