The cost of zero

In an era of extremely low interest rates in most of the developed world, pricing the cost of equity capital becomes a real problem. When debt capital is close to zero, then equity capital theoretically becomes extremely cheap, too. The 90 day Treasury bill is at 0.24%. Translating that into an earnings multiple (by turning the interest rate upside down to make an earnings multiple, or price earnings ratio) that 0.24% translates an earnings multiple of over 400.  In other words, on the standard ratio, companies can take over 400 years for profits to pay back their share value. That is an absurd result. But is it any wonder that equities seem overpriced in the US? A report by Morgan Stanley sounds a note of caution about the bullish sentiments in the market, arguing forecasts are too optimistic:

It says:

Developed-market earning forecasts look too high. Consensus expects a 30.8% increase in EPS between 2012 and 2010 (for the MSCI developed market index). EPS in 2010 was only 9% below the prior all-time high; earnings in 2010 were around the all-time peak once account is taken of dilution. In short, consensus expects 31% growth from a base of peak earnings.

An improvement in profit margins is one of the surprises. American corporates are cashed up and even enjoying pricing power. The finance sector has neatly socialised its losses, leaving government on its knees and the middle class under extreme pressure. But hey, business is good. Capital is cheap, profits are fine. The Morgan Stanley report says:

Corporates have seen a spectacular improvement in margins. As I’ve noted in hindsight (I did not expect this), profits saw a V-shaped recovery despite the tepid western-world GDP recovery. An unprecedented share of the initial recovery accrued to profits in the US. Exhibit 1 shows the four quarter change in gross domestic income, split between profits and the rest. Corporate profits accounted for all the increase in total income in the first year of recovery. Profits typically rebound faster than GDP in the initial recovery from recession, but never before has all of the first year of recovery fallen to businesses’ bottom line.

So let’s get this straight. The finance sector pulls of one of the biggest transfers of wealth in history (to put it as kindly, even inaccurately, as possible). This forces government to make money virtually free to stop the system from collapsing. Which means that business gets easy money and fat profit margins (oh, and the finance sector makes a fortune from the spreads). Bonuses return, business is good.

Who needs government? Or a middle class?

Morgan Stanley

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  1. Sorry SoN that “off” was meant to be a correction (above) ,4 above (bottom)
    I hope..cheers

  2. Yeah no one could accuse corporate America of not doing their best for shareholders.

    Capitalism at its worst

  3. C’mon SoN, using the 90 bank bill rate as the cost of equity to imply a PE is more than a little, ahem, disingenuous.

    You’ve heard of the equity risk premium, you know it’s probably at least 5% for the Aussie market. You also know that an equity free cash flow stream has a long duration, so using the five or ten year govt bond rate (at circa 5.25% or 5.50% respectively) is a more appropriate risk free yield to base any discount rate from. Makes the cost of equity somewhere around 10% (WACC a little lower by the time we load some debt in), then allow for perpetuity inflation growth of say 2.5% and a discount rate somewhere around 6%ish pops up. There’s a little bit of a spread between that and your 0.24%, n’est pas?

    With that dial-a-value framework, you could make a tidy living writing takeover defence reports 😉

    I do agree with your sentiments in relation to the banking sector (and I always enjoy reading Gerard’s — Morgan Stanley analyst — notes). Pricing systemic risk hasn’t been addressed although at least Basel III will bring the blunt hammer of more capital to bear on the problem (and lower bank ROEs).

    The local argument du jour is that the ASX is cheap on a PE basis, but if the resources sector is at/near peak cycle earnings and bank profits won’t grow as fast as they have (more capital, lower aggregate credit growth) then PEs should damn well be lower. But as with most broker strategists (Gerard is an exception IMHO), never let the facts get in the road of a good (i.e. bullish) story. As they say on Wall St, bearish equals unemployed.


    • Cash has no value beyond what you can obtain with it – goods, services and absolution (for your tax liability).

      (Fiat) government bonds are really no different from cash, except they have a coupon rate (now nominal) and an expiry date. They are essentially interchangeable with cash.

  4. Hi John_Motu, Of course there is a risk premium for equities, but the earnings yield (pe upside down) can be compared with the prevailing interest rate to get some kind of relativity. I am not proposing that anyone employ it for investment, I am using it as a way to exemplify how out of whack things are (one might add that shares can be traded v quickly, so the 90 day bank bill isn’t so short term from a trader’s perspective). But it is just a vehicle for a point, not a serious metric.