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DCFs break down with near-zero risk free rates!
Damodaran have no problem with Bernstein's equity research analysts abandoning DCF and switching to pricing stocks instead, but he believes that they need to do it for the right reasons. (Vir: Damodaran Online)
In any version of a risk and return model for discount rates, where you start with a riskfree rate as a base and build up to costs of equity, debt and capital, it seems blindingly obvious that as interest rates go lower, discount rates will follow and that value will increase. It is this logic that has led to the hand wringing about how central banks have both created pricing bubbles and made discounted cash flow valuations implode by “lowering’ rates. In a recent article, Sanford Bernstein proclaimed DCF all but dead in a world with near-zero risk free rates, because as they see it, the resulting low discount rates were pushing up the value of future cash flows, and since these cash flows are inherently more difficult to estimate, DCFs were less reliable. I have no problem with Bernstein's equity research analysts abandoning DCF and switching to pricing stocks instead, but I believe that they need to do it for the right reasons, not the ones outlined in that thought piece.
The risk free rate is an input into a discounted cash flow valuation but it is not an input that can be changed in isolation. When risk free rates change, they reflect shifts in fundamentals that should also show up in risk premiums and growth rates, making any resulting change in value difficult to forecast. As the hysteria mounts ahead of the next FOMC meeting, my suggestion is that you step back and take a big-picture perspective. This too shall pass!