How monetary policy could ultimately distort the valuation of private companies
In the valuation of private companies, the Capital Asset Pricing Model has been the default model for the past 60 years to calculate required returns. But we should use it with care today and tomorrow because of global monetary policies and their effects on stock market returns.
The origins of the Capital Asset Pricing Model and its use in valuation
The CAPM was introduced by Jack Treynor (1961, 1962), William F. Sharpe (1964), John Lintner (1965 and Jan Mossin (1966) independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory.
Despite its critics and the emergence of competing risk-quantification models such as the Arbitrage Pricing Theory and the Fama-French three-factor model, the CAPM is still the dominant model used today to quantify the required return for risk assets.
Its popularity comes from its ease of use and the flaws in the other alternatives. The network effect also helped because the CAPM model became mainstream in the 1970s and Finance students today still first learn of the CAPM when they learn about risk and return.
The CAPM was developed based on empirical stock market data from the 1930s to the 1960s
The development of the CAPM model was based on empirical studies of the stocks prices movement between 1931 to 1965. In August 1971, Richard Nixon severed the linked between the US dollar and gold as part of his sweeping economic plan. This meant that the value of the dollar was because the US government promised it rather than from the backing of gold holdings.
Given the importance of the discount rate in the valuation of a risky asset, we need to appreciate how and why required returns change yearly and sometimes illogically.
In the CAPM model, there is the:
i. Risk-free rate (e.g. 10 Year Treasury Yield)
ii. Equity Risk premium = Equity market return minus the risk-free rate
iii. Beta
Based on our research, the implied cost of equity using the CAPM model has been a wild ride - more connected to the financial economy than the real economy.
When we use the CAPM model to value unquoted equities today, we should not blindly apply the formula without at least understanding the impact of monetary policy in the past 10 years.
Let’s start –
1) Risk Free Rate – The risk free rate has been generally falling since 2008 as the US Federal Reserve injected liquidity to help resolve the Great Financial Crisis (2008 – 2009) and the impact from the Covid-19 pandemic (2020). The 10-year Treasury yield was 1.08% in 2021.
2) Printing to infinity – The stupendous increase in money supply was one of the key factors in the decline in the 10-year yield. The money supply in 2021 was USD 20.7 T or 15 times that in 2007.
3) The real economy did not grow proportionately - The US GDP did recover but not all the money supply went into the real economy. We observed that the money supply increased 350% (by USD 16T) and the USD GDP stayed largely flat (USD 21T) despite the bazooka monetary intervention.
4) The velocity of money is at a 15 year low - All the massive liquidity in the economy did not translate proportionately into GDP growth. As a result, the velocity of money as of 2021 was at a all time low. Velocity is a ratio of nominal GDP to a measure of the money supply (M1 or M2).
This means that the extra money is not being used sufficiently for productive activities. The velocity of money is a measure of how people are actively trading with each other which translates to GDP eventually. The velocity was 10.6x in 2007 and only 1.1x in 2021.
5) The stock market ended at an all time high - The stock markets became the beneficiary of the excess liquidity. Looking at the chart below, a visitor from Mars would not have guessed that the end of the world was nigh in 2020. The S&P 500 was at 4,573 points by December 2021.
And Price to Earnings Ratio was at a all time high in 2021 if we excluded the crisis years (2008 and 2020).
We then calculated the hypothetical cost of equity from 2007 to 2021 using the CAPM model
The large dispersion of the cost of equity from 2010 to 2021 is interesting and vexing from a valuation point of view. This could result in significant differences in valuation of private companies even year-on-year.
We note that the increase in the cost of equity in the recent years (2018 onwards) were driven because of the higher stock market returns which offset the decreasing risk-free rate. This seems plausible because investors were seeking more risky assets to compensate for the very low interest rate environment.
Interest rates are expected to increase very soon to tame runaway inflation and high interest rates are generally not good for stock markets.
Therefore, when we value risky assets, it is useful to understand the key drivers of the required rate of return and at least mentally reconcile the components to macro-economic trends.
We expect the required rate of return to be highly volatile going forward.
The CAPM is not going to vanish in the foreseeable future. We believe that the valuer needs to be more careful in evaluating whether the required rate of return makes sense when he does the valuation.
Our inhouse study has shown that just blindly applying a formula without understanding the global monetary policy can result in a valuation that is not as robust.