Hi I'm Jimmy and this video I'm going to look at whether or not it's possible that stock
prices are not overvalued despite the fact that we're going on one of the longest bull runs in history.
So for anyone who knows me well they know that I tend to let the numbers tell the story.
And if you've been a part of our channel at all well you'll know that there are two video
series that we've been working on right now with the Dow 30 analysis that we're just finishing up.
And in that series we've analyzed all 30 companies in the Dow Jones Industrial Average.
Then we're just about to present the three different portfolios that we tried to build
based on that analysis a value portfolio a dividend portfolio and a growth portfolio.
So there are links in the description below to all 30 companies that we did the analysis on.
If you're interested in then in the next year we're about to start. Well that's our valuation series.
And there I intend to go through as many possible ways to calculate the intrinsic value of a
stock as we possibly can. We're going to look at when to use each valuation method.
And we're gonna walk through actual examples of those of the calculations of the intrinsic
value or fair value whatever you want to call it.
We're gonna try to do that for virtually all publicly traded companies at least as many
sectors as we possibly can. So that's coming up.
And if that's something that sounds interesting to you hit the subscribe button because it's gonna be a ton of fun.
So the reason I bring all that up here is that as I'm going through updating the valuation
numbers for all 30 companies that we did in the Dow 30 analysis while I'm also prepping
the master list for all the different valuation techniques that we want to cover because I
want to be sure to cover as many possible valuation techniques as possible.
So if you have any thoughts on unique valuation techniques that you've heard of or you'd like
to learn more about post them in the comments below and I'll be sure I can include them
when I when we begin that series.
I'm trying to come up with a fair value for each of the companies in the Dow as of today
not back when we shot the video.
Well I started doing the math and quite a few of them looked like they were trading
at a decent value right now.
And if we'd pair that with the fact that I heard Buffett say this I think stocks are
ridiculously cheap compared if you believe that you're going to have that 3 percent interest
30 year bonds makes sense. That's a big "if" though.
So that's what makes going to work.
So that was part of a conversation on CNBC that Buffett had with Bill Gates and Charlie
Munger and both Gates and Munger came to the same conclusion as Buffett if rates stay low
then stocks look cheap.
So how does this work and how does low interest rates impact our valuation of the Dow 30 companies
or pretty much any company that we were trying to come up with a fair value for.
So I'm sure that we all know that generally speaking the fair value of any stock should be based on its future cash flow.
Now maybe that's cash flow coming in the form of dividends
that we collect or perhaps it's the free cash flow of the company.
Then in theory the company takes that generated free cash flow and they try to grow the business.
And as the business grows well the business becomes more valuable.
On the stock market our shareholder price goes up and everybody wins.
So here's a very quick and dirty way of determining the fair value of a stock by discounting the
cash flow and then after we look at this I'll tie it altogether and then we could see if
we could determine where we think the stock market will ultimately go.
So we have our current cash flow projections for this completely made up company.
So maybe this one hundred and twenty nineteen is one hundred million dollars of free cash
flow or maybe it's one hundred dollar dividend that we expect to receive in this year.
Either way the concept would remain the same.
But when I created this spreadsheet I actually intended on using I was thinking free cash flow.
So let's just stick with that.
So in this example Well we estimate that this company this fake company is going to bring
in 100 million dollars in 2019 and then they're going to grow by 15 percent for four years.
Then it grows by 12 and a half percent for another four years then 10 percent for four years.
And I keep stepping it down every four years until we hit our perpetual growth rate of 2.5 percent.
So right here is where we can see the perpetual growth rate and that growth rate was used
to calculate the terminal value which you may have noticed at the end of all all of our projections.
So I'll dive more into that when we do our discounted cash flow video.
But basically the perpetual growth rate determine it comes up with the number that we believe
free cash flow in this case will grow by every year forever by the way this type of growth
is actually called a multi-stage model where you have different levels of growth based on different time periods.
Here we used. We changed it about six times and that's actually a little bit crazy.
Usually the way I've seen it done is maybe two or three times you might change it but
this is a made up company so we could do whatever we want with. Either way.
Now we have our projected free cash flow and we're fairly confident in our free cash flow projections.
We believe that they're going to be accurate.
So now the question is what are all these future cash.
What is all this future cash flow worth today.
And to do that we must discount each of our projections by our required rate of return.
And typically we would each individually determine our own required rate of return.
Generally we would base the return that we require from our investments.
We would base that on maybe our investment goals or assets or liabilities.
How long we think we're going to be invested for taxes.
We'd probably want to account for inflation.
We would probably in theory want to account for the riskiness of the investment.
All of that gives us our required rate of return.
So then we discount all of our projected free cash flow numbers by our required return.
In this case we have seven point five percent.
And then we would account for the debt of the company we made up the company so they have no debt.
We divide that by the number of shares outstanding and we end up with the fair value of the stock.
In our case our fair value for this stock is one hundred nineteen dollars per share.
OK.
So all of that is simple enough. But what does this have to do with interest rates.
Well right now the 10 year U.S. Treasury bond is trading at a yield of about 2.5 percent.
So in our example well we assume a required rate of return of seven point five percent.
Well we made that decision knowing that if we wanted to we could have bought the 10 year
treasury bond and we would have gotten 2.5 percent and if we hold everything else the
same for the moment well we can say that really what we determined is that we wanted 5 percent
more than the risk free rate.
And generally speaking the 10 year U.S. Treasury bond is the default for the risk free rate.
Now whether or not we believe this is actually true whether or not it's actually a risk free
rate well that's a debate for another time.
Let's just assume it is for now.
So we know that we want a 5 percent spread on top of the risk free rate.
Again I'm oversimplifying this a bit but the concept holds true.
So if we require a return of seven point five percent and we believe that our future projected
free cash flow numbers are accurate.
Well then if we paid exactly the fair value that we calculated one hundred nineteen dollars
then our our return would be seven point five percent a year which is our required rate
of return.
That fair value price tells us the price we should pay to collect our seven point five
percent.
Of course assuming the market prices it the way we think they should.
Now let's pretend that this company is currently trading at one hundred dollars per share.
Well since we need seven point five percent that's our required return.
And we get that if we pay one hundred nineteen dollars per share.
Well one hundred dollars a share looks like a pretty good deal right now.
And we might even say that this stock looks ridiculously cheap to use Buffet's words so
ridiculous is probably a bit of an exaggeration In this particular example but we get the
point.
Now this brings us full circle back to interest rates.
So what if the 10 year Treasury bond wasn't 2.5 percent.
What if it was 5 percent.
Well you would never accept a seven point five percent return when it's thought we could
get 5 percent for risk free investment.
Why would we.
So let's imagine we still want a 5 percent spread on top of the risk free rate.
So now instead of seven point five.
Now we want a 10 percent return.
So our required return goes up from seven point five to 10.
Well assuming that everything else with the stock stays exactly the same.
Nothing else will affect the company.
Free cash flow is still projected to be the same thing.
There is no debt for this company so there's no implication with bond yields.
So assuming everything else is the same.
Let's see how it impacts.
So now with just a 2.5 percent increase in the risk free rate.
Well now the fair value of our stock is just seventy dollars per share.
So just like that our stock loses forty nine dollars in value.
It was calculated to be one hundred nineteen dollars before and now it's just seventy dollars.
So this is the exact reason that Warren Buffett Bill Gates and Charlie Munger would all agree
that with low interest rates well the stock market can keep moving higher.
Now in the CNBC video I keep referring to I actually have a link in the description
below.
If you're interested in watching the entire video well they're talking about this because
while just a year ago the US Federal Reserve was talking about raising interest rates.
Now they're actually talking about keeping them flat for at least a while.
And they almost have to keep them.
They have to stop raising them because they're worried about an inverted yield curve actually
have a video on the inverted yield curve if you're interested in learning more about it
like in the description below.
But basically it's a bad sign if the yield curve inverts.
So this is the current yield curve as it is right now and an inverted yield curve would
be when longer term rates have lower interest rates than short term rates.
So it would look something like this red line does.
But interestingly the Federal Reserve desk doesn't directly control any of these rates.
In fact they control the fed funds rate which has an overnight rate.
So that would be at about this time period here.
And we could think of this as how much impact they have on each of the time periods.
So clearly the further we get away from the overnight rate well the less impact the Federal
Reserve has on interest rates.
So as they started raising interest rates well essentially they were banging up short
term rates while the market kept longer term rates disproportionately low relative to the
short term rates.
So that's why they're going to have trouble raising short term rates up much more because
if they do the yield curve might invert further than it has in recent months.
And that could be a problem for the year for the economy in general.
So when we switch over to the 10 year Treasury bond well we can see that Treasury bonds have
been falling.
And this is important when we're trying to come up with our valuation for our Dow 30
stocks or pretty much any stock that we're looking at.
So when we did our previous videos well they would have all come in recent months where
interest rates were likely higher than they are right now.
So when we turn around we calculate the fair value.
When I was calculating it it turned out that I was using a lower risk free rate.
I didn't realize it and I was like wow why are the valuations coming up higher than I
would have expected.
And the key driver to that was the lower risk free rate lower risk free rates leads to a
lower required rate of return lower required rate of return higher intrinsic value.
So our question is do we think that interest rates will stay low.
And if they do.
Are they likely to stay that way for at least a while.
So if they do perhaps stocks are not as overvalued as people believe there.
I still think that we need to watch the economic indicators that come out and I plan on putting
together another video on that topic at some point in the near future.
But what do you think are stocks currently overvalued fairly valued or undervalued at
this point.
If we believe interest rates will stay low at least let's say the next year or two.
Well stocks could be fairly valued maybe even undervalued.
But let me know what you think of the comfortable.
If you haven't done so already get the subscribe button.
There's got lots of good videos coming out in the near future.
If you found this video interesting hit the thumbs up.
Thank you for sticking with me all the way to the end of the video.
I see in the next video.
Thanks.