Investing Club: Here are two ways to value stocks and they both hinge on interest rates

Published Mon, Mar 28 20222:53 PM EDT

Investors are getting a slight reprieve heading into the final days of March from the stock market's bout of extreme swings surrounding the fallout from Russia's invasion of Ukraine. We felt it would be helpful during the lull to review the recent volatility so that we can better understand what happened and be more prepared the next time. One of the ways to be more prepared to navigate market turmoil is to understand how stocks are valued as well as how inflation and interest rates affect those valuations. To start, let's consider a discounted cash flow approach. Discounted Cash Flow dynamics Stocks are valued on future earnings and cash flows. We generate a present value for companies by estimating these outyear numbers and then discounting them to the present day using a discounted cash flow (DCF) model. When interest rates are at essentially zero, the denominator in a DCF model is lower and as a result, investors can speculate and look out into the future as far as they want. However, when rates rise, the rate of return investors require for the risk they are taking on by owning equities must increase. That increased denominator means that present value of future earnings and cash flows declines. The further out those earnings are, the less they are worth today with every tick higher in rates. To better illustrate this, let's consider an example of how a higher discount rate impacts future earnings. Company A is a high-flying tech stock with a promise about the future but no earnings power today, making it a longer duration asset in the context of stocks. Examples of a situation like this might be something in the electric vehicle industry that came public via a special purpose acquisition company (SPAC) or maybe an enterprise software company. Company B is a value cyclical name, like a large-cap financial or industrial. These companies are traditionally thought of as short-duration assets. Let's compared the two. Company A is expected to generate $10 of earnings per share in 2027, five years from now, while Company B is expected to make $10 per share by the end of 2022. An increase in rates means that Company A's earnings are discounted back to the present five full years at a now higher rate, while Company B's must only be discounted back one year at that higher rate. When rates are on the rise, the impact of discounting to the present day has a larger and larger effect the more years you have to do it. This causes investors to seek out shorter duration assets like Company B over stocks like Company A. Ultimately, companies A and B will both generate $10 in earnings. However, the present value of Company B's $10 in earnings is worth increasingly more relative to Company A's as rates rise. That's why we want to own the stocks of companies that generate real profits today. The closer those profits are to the present day, the less impact rising rates have on their present values, making those earnings more attractive compared with those of the high-fliers that see their present-day intrinsic values drop on higher rates. Valuation Multiple dynamics Stocks can also be valued via a multiples-based approach. In general, investors looking more near- to- mid-term — six to 18 months out — will look at a company's price-to-earnings ratio. For example, Club name Apple (AAPL) is expected as of this writing to earn $6.15 per share in fiscal year 2022. So at a price around $173 per share midday Monday, the stock trades at 28x earnings. However, similar to reassessing the discount rate in a DCF model when rates rise, investors must also reassess valuation multiples, especially in the high fliers and particularly in the names that don't even have earnings and therefore trade on sales-based multiples. This is what you hear being referred to when investors mention "multiple contraction." When rates go up — or are expected to go up — investors value companies using a lower valuation multiple. It's also crucial to understand because when a re-rating occurs, we often cannot look to recent highs, especially in the high fliers, as the environment has changed and the market may simply be unwilling to look back at the multiples applied in the lower rate environment. This is why lower multiple names tend to come into favor as rates rise. These so-called value stocks typically already have low multiples, making the risk of contraction less of an issue. Lastly, one more term you will often hear in this market is GARP or growth at a reasonable price. This is the term used for those names that strike a nice blend of growth and value. These names may therefore be able to hold up better when the selling hits the high fliers while still providing exposure to underlying business growth. Don't fight the Fed The one dynamic that will impact all valuation models is interest rates. When rates are rising — either because of Federal Reserve action or bond market movements, investors must increase the discount rate used in a DCF-model to better reflect the risk they're taking on in equities, given a more attractive risk-free rate. Many use the 10-year Treasury yield as a proxy for this "risk-free" rate. This higher discount rate will pull down the present value of those future cash flows. Another way this may be reflected is via a contraction in valuation multiples. We have certainly seen this over the past few months. However, it's important to differentiate between the stocks where rising rates may hit earnings, and those where they're largely impacting only the valuation multiple investors are willing to ascribe the stock. Bottom line This is why, when volatility strikes, it's crucial to look for stocks of company's where the price has come down — the numerator in a P/E valuation model — but the underlying fundamentals and therefore earnings power — the denominator — remain intact. When you find a company like this it means the stock actually is getting cheaper. So just as you do when your favorite store has a sale, you should be looking to buy, not sell because the item you're getting is just as good as it was a month ago but it's selling at a lower valuation. You're paying less per dollar of earnings. This is not the case when the fundamentals are deteriorating. In that case, the price may come down but if the earnings power declines the stock doesn't get any cheaper. If anything, it may actually be getting more expensive. (Jim Cramer's Charitable Trust is long AAPL. See here for a full list of the stocks.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. If Jim has talked about a stock on CNBC TV, he waits 72 hours after issuing the trade alert before executing the trade. THE ABOVE INVESTING CLUB INFORMATION IS SUBJECT TO OUR TERMS AND CONDITIONS AND PRIVACY POLICY , TOGETHER WITH OUR DISCLAIMER . NO FIDUCIARY OBLIGATION OR DUTY EXISTS, OR IS CREATED, BY VIRTUE OF YOUR RECEIPT OF ANY INFORMATION PROVIDED IN CONNECTION WITH THE INVESTING CLUB. NO SPECIFIC OUTCOME OR PROFIT IS GUARANTEED.

People walk along Wall Street near the New York Stock Exchange (NYSE) on February 16, 2022 in New York City.

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