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Let's Be Clear About Where We Stand

It’s no secret we’ve been concerned about U.S. stock valuations for some time. See, for example, our March 2021 post for a refresh on the Federal Reserve’s role in this process. By almost any metric valuations are in rarified air compared with history. Almost every measure of venture capital and private equity activity (capital raised, deals, exits) jumped dramatically over the last two years. More unicorns (companies with valuation > $1B) were minted in 2021 than in the prior five years combined.(1) Public companies (including IPOs) raised $306B in 2021 – more than the prior three years combined.(2)

At the very least we can say that current capital market conditions are highly unusual.

Many people in the financial markets benefit from a continuation of this exceptional activity. There’s always a story as to why current conditions, despite being so unusual, can persist. So it’s noteworthy to me when an “insider” is willing to call a spade a spade. In November, Scott Kleinman, Co-President of private equity giant Apollo Global Management did just that, reportedly saying that low interest rates are causing a “collective delusion” on deal valuations.

Data aggregator/analysis firm Pitchbook also recently noted that some venture capital veterans see similarities to the late 1990s.

Let’s back up for a moment.

Claims on the value of a business are always ultimately about cash flows. From startup to early stage to growth to late stage to public, everyone participates on the basis that either the business will generate cash flow to satisfy the claim, or someone else will purchase the claim based on the assumption that the business will eventually generate cash flow to satisfy the claim.

The method for valuing those claims is a fraction, with some sort of earnings or cash flow figure as the numerator and a discount rate (adjusted for future growth) as the denominator. Bond claims typically don’t grow and have an end date. Equity claims typically do grow and do not have an end date.

During periods of extreme equity valuation investors tend to construct very optimistic assumptions about the future on both sides of the fraction. Investors assume large future earnings (reflected in the numerator) and favorable growth rates for those earnings (reflected in the denominator). That was certainly true in the late 1990s for U.S. large cap, tech-media-telecom (TMT), and dot com companies.

As already noted, today we are in a period of extreme equity valuation. The reasons rhyme with similar past periods but are not exactly the same. Today the implicit assumptions are more extreme. For example, venture capital deals for some companies reflect very large future earnings (numerator) because there’s a presumption of (a) large TAM (Total Addressable Market); and (b) “winner take all/winner take most” dynamics for many tech sectors. But perhaps the biggest difference today compared with past periods – and biggest impact – is in the denominator, i.e., the discount rate itself. It’s what Scott Kleinman referred to as the “collective delusion” of low interest rates.

The assumption of large future earnings + low discount rates forever + high growth rates for businesses participating in the economy of the future = extreme valuation.

I’m not convinced today is the same as the early 2000s – at that time the delusion was amongst private economically-motivated investors. Today, another party plays a major role. That party is the government via extreme monetary and fiscal policy. Government is not economically-motivated – it has other objectives. Government has assumed extraordinary control over discount rates (denominator) since the financial crisis. And government can keep the game going for longer than any of us care to imagine. It’s clear that policy makers would prefer not to see a major reset of prices across the economy lest that lead to recession or worse. So the more likely path is to keep interest rates relatively low, keep asset prices relatively high, and let nominal cash flows catch up over time with a little help from inflation.

There’s still opportunity to be found, for those willing to look deal-by-deal and business-by-business. It’s just that we need to be very clear about where we stand today – and the assumptions we implicitly make about earnings, discount rates, and growth.




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