Falling Discount, Gold And Silver Get Powelled

Warren Buffet famously proposed the analogy of a machine that produces one dollar per year in perpetuity. He asks how much would you pay for this machine? Clearly, it is worth something more than $1.00. And it’s equally clear that it’s not worth $1,000. The value is somewhere in between. But where?

This leads to the concept of discount (which we mentioned in Falling Productivity of Debt two weeks ago). A dollar to be paid next year is worth less than a dollar in the hand today. One reason is that we are mortal beings. In order to be alive next year, we must remain alive every single day between now and then. There are natural reasons for time preference—the desire to have a good today, and not postpone it. We are also not omniscient. Something may come up, such as an illness, which forces us to consume what we did not plan to consume.

Another reason is, of course, risk. Unlike the magic machine in our example, a business enterprise may cease to make money for any number reasons including a new competitor or changing customer preferences.

For many reasons, a dollar to be paid next year is not worth a dollar today. A dollar to be paid in ten years is worth even less. Future payments must be discounted. The discount is related to the interest rate, and it shares many of the same causes.

It can be quoted as a yield if you look at earnings divided by share price. We aren’t going to go through the formula to discount future earnings into perpetuity here. However, the math works out. The current P/E ratio of S&P 500 stocks is 25.74. This is the same as saying the E/P ratio is 3.89%. If you discount a dollar of earnings every year into perpetuity, at 3.89%, you get 25.74. So we use discount rate and earnings yield equivalently, depending on context and the point we want to make.

The higher the price of the share, the lower the yield. With each halving of discount rate and hence earnings yield, the share price doubles. A nifty trick to create free money, eh? Just somehow lower rates and yields across the economy…

It should not be surprising that discount has been falling along with the interest rate. Let’s look at earnings yield again (ignoring dividend yield which is under the control of corporations, who have broad discretion to set the dividend, and hence not as clear a signal).

This chart is showing three things. First and most obvious, the earnings yield on stocks falls with the interest rate (as does marginal productivity of debt as we showed last week). And it makes sense, the more the Fed pushes down interest, then equities become more attractive. At least until their yields are pulled down closer to Treasury yields.

Second, yield purchasing power is falling. This is not how many groceries you could buy if you liquidate your stocks (as the mainstream view would have you think). It is how many groceries you can buy with the earnings of the businesses you own. Stocks are partial ownership of businesses, and as a shareholder, you have a portion of the earnings. As yield purchasing power falls, it takes more and more capital to generate enough income to buy food. At the current level of 3.89%, if you need $50,000 a year to live, you need about $1.3 million worth of S&P shares.

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Author: Travis Esquivel

Travis Esquivel is an engineer, passionate soccer player and full-time dad. He enjoys writing about innovation and technology from time to time.

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