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The Weighted Average Cost Of Capital
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The Weighted Average Cost Of Capital
This is a revisitation of a report I wrote back in late 2016, predicting the imminent end of zero-bound interest rates and warning of the downward pressure that rising rates, mathematically, must place on today’s elevated asset prices.
Since the publication of that report, interest rates have indeed vaulted higher. Look at how the 3-month US Treasury yield has exploded since the start of 2017:
A Little Background
When I was fresh out of college in the mid-90s, I landed a job at Merrill Lynch. I was an “investment banking analyst”, which meant I had no life outside of the office and hardly ever slept. I pretty much spoke, thought, and dreamed in Excel during those years.
Much of my time there was spent building valuation models. These complicated spreadsheets were used to provide an air of quantitative validation to the answers the senior bankers otherwise pulled out of their derrieres to questions like: Is the market under- or over-valuing this company? Can we defend the acquisition price we’re recommending for this M&A deal? What should we price this IPO at?
Back then, Wall Street still (mostly) believed that fundamentals mattered. And one of the most widely-accepted methods for fundamentally valuing a company is the Discounted Cash Flow (or “DCF”) method. I built a *lot* of DCF models back in those days.
I promise not to get too wonky here, but in a nutshell, the DCF approach projects out the future cash flows a company is expected to generate given its growth prospects, profit margins, capital expenditures, etc. And because a dollar today is worth more than a dollar tomorrow, it discounts the further-out projected cash flows more than the nearer-in ones. Add everything up, and the total you get is your answer to what the fair market value of the company is.
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Former Fed Advisor Asks “Has The Fed Bankrupted The Nation”
Former Fed Advisor Asks “Has The Fed Bankrupted The Nation”
Which one does not belong? Logic dictates that Volcker should have been odd man out. After all, there is no legendary “Volcker Put.”
The towering monetarist made no bones about never being bound by the financial markets. The same can certainly not be said of his three successors. And yet, history contrarily suggests it is to Volcker above all others that the financial markets will forever be beholden.
Many of you will be familiar with Michael Lewis’ memoir, Liar’s Poker. Yours truly first read the book in a Wall Street training program much like the one Lewis survived to describe in his autobiographical work. The take-away then, in late 1996, was that Gordon Gekko was right — greed was good.
Recently, a second reading of Liar’s Poker, following nearly a decade inside the Federal Reserve, delivered a much different message than did that first youthful reading and was nothing short of an epiphany: Paul Volcker, albeit certainly inadvertently, created the bond market.
On Saturday, October 6, 1979. Volcker held a press conference and announced that interest rates would no longer be fixed and that further the Fed would begin to target the money supply in order to curb inflation and “speculative excesses in financial, foreign exchange and commodity markets.”
Alas, this new regime was not meant to be. In trying to introduce an alternative to interest rate targeting, the Fed replaced one guessing game with another. Predicting the demand for reserves and then buying or selling securities based on that demand proved to be just as dicey as a similar exercise to target a given level of interest rates had been.
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