Question

1. Valuation issues. Explain why each of the following statements is generally incorrect:

a. “Price-earnings ratios should increase when the yield on government securities rises.”

b. “A company’s discounted cash flow value is usually dominated by the magnitude of its expected cash flow stream during the future five to ten years, whereas its terminal value usually has a negligible effect on its DCF value.”

c. “The use of high debt ratios to finance leveraged buyouts is essentially a device to capture the tax savings generated by the deductibility of interest expenses.”

Answer 1

a. Low interest rates help to grow the economy as everything is less expensive and even firms can operate with less expenses. This results in lower financing costs, as a result we can see good growth in earnings of the company. When earnings grow the stock prices increase. Higher earnings also mean higher dividends paid to investors. Higher stock prices and higher dividends mean higher investment returns. Therefore, the price earnings ratio increases. The average P/E ratio for the S&P 500 Index is inversely related to the 10-year U.S. T-Bill interest rate. In other words, the lower the interest rate, the higher the P/E ratio.

b. The assumption that Cash flows alone play an important role in DCF valuation than the Terminal value is absurd. This is because cash flow projections are only for the next 5 or 10 years, where predictability and understanding of markets is easier. Terminal value is the value of the business after the forecasted period. It assumes that the business will grow at a fixed growth rate. Terminal value estimates the company value into perpetuity.  Anything longer than the forecasted period and the accuracy of the projections suffer. This is why the terminal value is an important part of the DCF valuation.