Market participants have, for the most part, correctly attributed the violent downturn in tech equities to inflation and its impact on interest rates. And if inflation and rate hikes are the proximate causes of the decline in public markets, then it follows that they must have indirectly caused the corresponding slowdown in private investing and valuations.
This is about the extent to which I think the present phenomenon is understood. Most investors I speak to tend to think that the investment world will normalize later this year or early next; many founders I speak to still expect their businesses to be priced at 2020 and 2021 valuations and are still operating their businesses as if easy funding will continue (i.e., with no credible path to a viable business model).
The conceptual error here is that people have a tendency to over-extrapolate the past into the future. They think that whatever has happened in their recent memory will continue into the future. However, I think that a more mechanistic understanding of financial and macroeconomic theory would suggest that we are undergoing a paradigm shift of sorts, and that the next decade of investing and companybuilding is going to be very different than the last. In particular, the shift toward this new paradigm will be very painful for those who don’t adapt.
You know how to interpret the appearance of the sky, but you cannot interpret the signs of the times. 1
To this end, I think it’s worth returning to the axioms and first principles of investing.
Financial assets are claims on future cash flows. Naturally, one would prefer cash today to cash tomorrow. Therefore, in order to part ways with cash today, there ought to be the promise of more tomorrow. But how much more, exactly? Concretely, how much would it take to part ways with $100 today?
Because the future is uncertain, we can only answer this question with reference to a benchmark or “risk-free” rate, or an “opportunity cost of capital”. This rate allows us to convert cash flows in the future to “present value” terms. If the benchmark rate is 2%, then $100 today is worth $102 in one year, \(100 \times 1.02^2\) = $104.04 in two years, and so on. Equivalently, we say that \(100 \times 1.02^4\) = $108.24 in four years is worth exactly $100 today, or that we would pay $100 to be repaid that much the future.
Let \(r\) be the risk-free rate, \(CF_i\) be the cash received in year \(i\), and \(n\) be the term of the asset. We can then define an “intrinsic value” \(V\) of an asset as follows:
\[V = \sum_{i=1}^{n} \frac{CF_{i}}{(1+r)^i}\]Therefore, so long as \(r\) is positive, then the farther out a cash flow is in the future, the more the denominator penalizes it, which accords with our intuition that we prefer cash nearer in the future. Interestingly, when \(r\) is negative, then it means that longer-term cash flows are preferred relative to shorter-term cash flows, as the denominator becomes a multiplier for each subsequent term.
This setup is conventionally referred to as a “discounted cash flow” model, since future cash flows are “discounted” to their present value. It is the single framework off of which all other valuation frameworks are based. 2
While it may seem simplistic, understanding this framework sheds light on the nature and behavior of a number of different assets and their respective investors. A few selected examples below:
Given the above, here are a few meandering thoughts on culture, finance, and otherwise.
Rates and courage. By now it should be clear that \(r\) is a lever which policymakers use to control time preference of cash flows. When \(r\) is high (low), investors allocate capital to projects and businesses which create near-term (long-term) economic value. In some sense, because the world is uncertain, businesses which generate cash flow immediately are “safer” and businesses which may only be profitable after a long time are riskier. Therefore, it could be said that policymakers use it to control “courage”, where “courage” is defined as the willingness to take risk across time. In recessions, this is a blunt instrument to try to incentivize capital investment and economic activity.
Courage and ideas, narratives and reality. Courage does little good without ideas about what projects are worth building and investing in. But not all ideas are good, and good ideas are scarce. The quality of thinking tends to degrade in low interest rate, easy money environments. Since the far future is more speculative than the near future, we have to rely on abstractions and narratives, and it is comparatively easier to tell a narrative than to reify one. In this last cycle, there were many businesses and “assets” formed which had no expectation of cash flow, but instead had ambitious, “investable” narratives: a couple of kids in a college dorm with an idea, jpegs of monkeys, and other “software eats the world” narratives which only work when the cost of capital is negative. Because rates were so low, and money so plentiful, every narrative about the future was somehow worth considering if the expected discounted long-term payout had any shred of credence whatsoever.
Reality and the future. I don’t think I have any particularly groundbreaking predictions, but here they are anyway.
Matthew 16:3. ↩
Investors also frequently refer to “multiples” (of revenue, earnings, cash flow, or otherwise). While at a first glance this appears to be completely different than the discounted cash flow model, it is in fact a simpler approximation of the DCF. For instance, a price-to-earnings ratio of 10x can be inverted to obtain an earnings-to-price or “earnings yield”. This is simply a unidimensional variable which can then be compared against the yield of other assets, and which “bakes in” an expectation of future cash flow growth. ↩