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Pandemic has thrown out the textbook approach to valuing anything

Posted on 20 May 2020

Source:  SMH - Stephen Bartholemeusz

How do you value anything in the time of the coronavirus? Things are, of course, being valued. Shares, bonds, property and businesses are being traded despite the raft of uncertainties spawned by the coronavirus pandemic. Whether it's a share, a property - or a business like Virgin Australia -prospective buyers are having to think through the impacts of the pandemic on the particular asset. They know some businesses will be impacted more severely than others; that the duration of those impacts will differ from business to business and that the future trajectory of their cash flows will be dependent on the course of the pandemic.

That's a complicated set of equations, given the understanding of even the immediate impacts of the virus on companies' earnings and cash flows, or properties' rental incomes, isn't complete. Until there is more certainty about the timelines of the pandemic any attempt to assess its longer-term effects on individual companies or even sectors is essentially a guess.

Valuations have also been made more complicated by the reactions of central banks and governments to the pandemic. Extraordinary amounts of fiscal and monetary policy support have been injected into economies, obscuring the extent of the near-term damage to economies, businesses and households. Those measures aren't permanent and, regardless of whether the virus is contained or not, there will be considerable and permanent damage. Indeed, there already is. Even before the pandemic, valuations were distorted by the unconventional monetary policies pursued by central banks in the post-financial crisis era. Interest rates were at historically low levels and there were about $US17 billion ($26 billion) of government and corporate bonds carrying negative rates.

The conventional approach to valuing income-generating assets is to try to calculate their likely future cash flows, based on the history of the business or property and some assessment of the likely economic and operating environment. The value of those future cash flows is then discounted for inflation and risk to calculate their present value. When risk-free rates long-term government bond rates are close to zero, using the textbook approach to valuation and assuming that those low rates would be a permanent feature of the financial landscape would produce peculiar outcomes. The US 10-year bond rate is 0.73 per cent. The 30-year rate is 1.44 per cent. In our bond market 10-year bonds are yielding 0.96 per cent and 15-year bonds 1.24 per cent. In real terms the yields on those bonds in both markets are probably negative (unless you factor in an era of deflation) and point to a long-term future of anaemic economic growth. If long-term bond rates are ultra-low it essentially says bond investors are assuming those rates will persist, if not in perpetuity then for the life of their investment. If that were the input into a calculation of the net present value of a company or property, it would imply near-infinite increases in the value of those assets. While to some degree that is the way the sharemarket has behaved in the post-financial crisis period, responding to the traditional inverse correlation between bond yields and share prices by continually bidding share prices up, that's clearly not a sophisticated or sustainable valuation approach.

Estimates of the duration of the virus and its after-effects will be critical to valuations. The concept of the "time value" of money is based on the notion (the reality, before negative interest rates) that a dollar today is worth more than a dollar tomorrow, or the next day, or the next year or a decade away. That means the near-term experience has a much greater impact on valuations than the future. For most companies, and landlords, the coronavirus means materially reduced cash flows during the lockdown periods and then some recovery as economies reopen, with the risk, of course, of further outbreaks and interruptions to business.

For some industries, such as aviation, the timelines for what will be a delayed and protracted recovery to what will probably be a new and less prosperous normal will be quite stretched, assuming survival. That ought to mean risk premiums for shares, properties and businesses ought to be soaring and valuations falling to reflect the uncertainties and the reality that the post-pandemic is riskier than the preceding period.

Property values, residential and commercial, do appear to be sliding as households become more cautious and the query over rental incomes increases in line with the deteriorating financial health of most tenants.

Share prices initially slumped about 34 per cent in response to the emergence of the pandemic but have since bounced back to be less than 13 per cent off the record levels set in February. Implicit in the way sharemarket investors have behaved since late March is the capitalisation of a 'V-shaped' recovery into their projections of the future and, effectively, a return to the near-complete absence of any pricing for risk that, thanks to central banks, has prevailed for most of the past decade.

Given the number of pandemic-associated variables with undefined dimensions, that would appear to be a rather risky approach, albeit one that could produce big returns for those with healthy appetites for risk, assuming they are conscious of the risk.

There is a quote attributed to Warren Buffett's mentor, Ben Graham, that might be apposite. "In the short run the market is a voting machine but in the long run it is a weighing machine." For the moment, the market for financial assets and real property and real businesses appears to be underwritten by sentiment by optimism and in equity markets by the post-GFC conviction that ultra-low interest rates will always put a rising floor under share prices. In the longer run, however, it will be the weight of the post-pandemic cash flows that will sort out what those shares, properties and businesses are really worth.

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