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The theory of present value states that the price of a stock is the discounted value of the infinite stream of future income of the company.

Several countries have had very very low interest rates, very close to zero. Yet, stock prices have not gone to very very high values, or even infinity.

Why is this the case? Is this a proof that the theory of present value is incorrect? Or maybe investors think companies will not last "forever" (which they cannot, as earth's lifespawn is finite)?

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  • $\begingroup$ I would have difficulty thinking of any US corporation which I am confident will be in business 20 years from now ... or even 10 years from now. $\endgroup$ – Hot Licks Dec 14 '17 at 22:31
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Equities and some other asset classes have gone up in price.

However, just because interest rates are very close to zero, does not mean discount rates are very close to zero.

Discount rates account not only for the price of money, but also for future uncertainties.

The extended period of depressed demand in many nations has added considerably to the uncertainty.

Hence, some asset classes have increased in price, but not to extreme values.

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More sophisticated calculations of present value account for:

  • uncertainty: this is for example assuming different scenarios of cash flows, and assigning probabilities to them.

  • risk premium: you are referring to a "risk-free" interest rate, whereas companies are subject to risks, including bankruptcy or technological displacement. Thus, to discount flows the rate of discount used is different, and higher. Even more, the longer the period, the higher this rate should be. This is, estimates of cash flows in 50 years more have little effect on the current price stock.

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