r/valueinvesting
CMV: Extreme valuations are not always irrational. Sometimes they just mean the buyer is accepting a terrible return.
High valuations for NVDA/TSLA may be mathematically rational due to low discount rates, but imply terrible forward returns.
- High valuations can be mathematically consistent if buyers accept very low discount rates for scarcity or optionality.
- High valuations driven by low discount rates imply awful forward returns, meaning they are not good investments.
People often look at companies like SpaceX, OpenAI, Nvidia, Tesla, etc. and say something like: “This valuation makes no sense. The market has gone insane.”
I’m not sure that’s actually the right conclusion.
A valuation can look absurd without the math being absurd. It may simply mean that the buyer is using, whether explicitly or not, a very low discount rate.
Take the basic perpetuity formula:
Value = Cash Flow / Discount Rate
Or:
PV = CF / r
Now take a silly example.
Suppose an asset will eventually generate $0.01 of free cash flow every year forever.
At a 10% discount rate:
$0.01 / 0.10 = $0.10
At a 1% discount rate:
$0.01 / 0.01 = $1.00
At a 0.1% discount rate:
$0.01 / 0.001 = $10.00
At a 0.01% discount rate:
$0.01 / 0.0001 = $100.00
And so on.
Push the required return low enough, and even a tiny perpetual cash flow can justify a huge valuation.
So when people say, “There is no way this company is worth X,” I think the hidden question is:
Worth X to whom, and at what required return?
If the marginal buyer is willing to accept a 2%, 1%, or almost zero expected return because they want access, scarcity, optionality, status, indexing exposure, or simply exposure to a one-of-one asset, then the valuation can look insane while still being internally consistent.
That does not mean it is a good investment. It may actually mean the forward return is awful.
But “awful forward return” is not the same thing as “irrational valuation.”
And I think this also applies to value investing.
A lot of value investors talk as if this problem only exists in growth investing. I don’t think that’s true.
If your DCF depends heavily on:
- a very low discount rate,
- a huge terminal value,
- a moat lasting longer than expected,
- normalized margins that may never come back,
- or a business surviving indefinitely,
then you are also making a big claim about the future. It just looks more respectable because it’s inside a spreadsheet.
So maybe the real divide is not value vs. growth.
Maybe the real divide is:
What return are you actually underwriting?
My view is that many “crazy” valuations are not necessarily proof that the market has lost its mind. They may just be proof that the marginal buyer is willing to accept a much lower future return than the critics are willing to accept.
CMV.
My pushback would be that in any investment scenario you always have to weigh an investment against your next best alternative.
Interest rates are in essence the price of time, they are to the financial world what gravity is to the physical world.
So in a world with a risk free rate of 4% or 4.5% why would you get excited to take on equity risk at a 3% cap rate? Perhaps in a world where the risk free rate is 0.5% a 3% cap rate would give you a substantial spread over the “gravity” of interest rates. Now flip this scenario on its head, if the risk free rate climbs to 20% suddenly a 15% return on a risk bearing asset is not very attractive relative to the 20% risk free rate.
Another pushback on using an extremely low discount rate comes back to the “next best idea” analogy.
Why choose a risky asset and target a 1% discount rate, when you could choose an arguably less risky asset that given the same discount rate exceeds your required rate of return.
Due to the lower price paid for a given cash flow and a higher degree of certainty over the long term outlook of the business it would certainly be a less risky way to achieve your required rate of return. Therefore by that logic it would be irrational to take on more risk to hit your target return, unless of course you are expecting someone to pay an even higher price for the already unreasonably priced asset in the future (greater fool theory) and at that point you are just speculating
Isn't accepting a terrible retirn irrational?
It’s a just FOMO is all
What's the incentive for lower return in the future?
Why would someone accept such low forward returns when they can get 4% risk free? Which is what brk is doing btw
I think it depends on the stock, and the quality of the business. I think some stocks have truly earned high multiples. Like tj Maxx, Costco, intuitive surgical, asml, and visa.
If you were to wait for any of these stocks to become "value" they would have absolutely blown you by.
I think value is all relative to what the company is. There is a fundamental difference between a struggling consumer Staple, and a company that generates enormous profit, has a most, and is still growing.
I've learned, it's better just to pay for quality, and what is "value compared to the market" and what is value compared to the historical norms of the company.
I also think there's a difference between a hype stock at nosebleed multiples with nothing to show for it besides "the future" and a company that has demonstrated year after year to be a strong compounder.
Using DCF as the analytical framework, two people can come to different estimates of fair value based on two criteria: first, as you say, different discount rates. The second, which you ignore, is different cash flows. In theory, the path and confidence band surrounding those estimates should be the key drivers of a discount rate.
I think you're really glossing over the fact that tech bulls (or whatever company you think is overvalued) probably aren't assigning a 0.1% discount rate on future cash flows in a world of 2% real yields and 4-5% nominal yields. You're sort of haughtily dismissing them as dumb and inefficient allocators of capital.
A more charitable interpretation of those investors is to say hey, they genuinely believe future cash flows on these stocks are going to be way higher than what I think. Why do I think they are wrong? Why might they think I am wrong? What can I learn from their views to improve my own understanding?
I think this a much more productive exercise than just assuming people don't understand opportunity cost of capital. These stocks have lots of narrative based, retail minded investors in them but also a lot of pretty intelligent investors. Try and learn from the smart people that are in these stocks, even if you ultimately disagree with them.
Great answer thanks!!
well of course crazy people believe they're being rational!
I don't think any reasonable person will disagree with the general principle of what you're saying. Some people DO just want the access/privelage of owning an asset regardless of valuation. But what do we call that? We usually call that a market bubble...
Your idea only makes sense if SPCX is the only stock on the market.
Otherwise the hurdle for terrible acceptable returns is more easily meet by many other stocks