Given how much this market crisis has shaken our faith in systems and numbers, it is no surprise to me that the most common question that I have faced these last few weeks is about how this crisis has changed the way I do valuation.
Before I answer, let me specify what has not changed for me. The intrinsic value of a business is still a function of its capacity to generate cash flows in the future. In other words, I am not going to create new paradigms for valuation just because we are in turmoil. In terms of estimates, though, here is what I believe has changed in these last 6 weeks:
1. The risk premiums we demand for investing in equities as a class and in corporate bonds has increased significantly. On September 12, the equity risk premium in the US was 4.2%. On October 16, it was greater than 6%. The key question we face is whether this is an aberration, in which case equities are massively under valued or whether we are facing a structural break, where we face higher risk premiums from now on. I think the answer lies somewhere in the middle. This crisis has increased equity risk premiums and default spreads for the next couple of years, but I believe that risk premiums will revert back to lower values (4-4.5%) in the long term. (Equity risk premiums in emerging markets have to be scaled up accordingly)
2. It is beyond debate now that there will be consequences for economies globally. The slowdown will affect real economic growth (and consequently earnings growth) next year for companies around the world.
3. The long term consequences for individual companies is likely to be mixed. The shake out and more limited access to capital will put smaller companies at risk and drive many of them out of business. Larger companies will strong balance sheets and significant competitive advantages will emerge the winners from this turmoil. The higher excess returns that they will earn will give them higher values.
I just put together a presentation this morning on the crisis and its impact. If you are interested, you can download it by clicking on the link below.
Hope you find it useful!