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  • BentonMD BentonMD Aug 15, 1998 10:19 AM Flag

    The intrinsic value of Pepsi

    One of the problems with using the perpetuity
    formula for anything during times of very low interest
    rates, (such as now, as the long bond is at the lowest
    rates since being issued in the 70's), is that prices
    can quickly approach infinity. This is due to the
    convex nature of a bond's yield. I am sure most of you
    are familiar with basic bond math, so suffice it to
    say that it takes a correspondingly greater increase
    in the price of a bond to go from 6% to 5% than from
    10% to 9%.

    Let's say that we are now in a
    period where interest rates will remain permanently low,
    due to, say, massive global oversupply, Asia's
    recession, whatever. Now, if you were to use the long bond's
    yield of 5.537% to discount your growth rate of 5%, the
    prices approach absurd levels. At these rates, every
    dollar of earnings would be valued at over 186 dollars!
    The same dollar using a discount of 7% would be worth
    50 dollars, still not cheap. And as rates go lower,
    the problem becomes worse, especially when you
    consider what happens if (when) rates start to rise again.
    These astronomically high valuations quickly plummet to
    earth, causing massive asset devaluations.

    if you have a company expected to grow at 5%
    forever, and rates continue to go lower, how do you use
    this equation effectively??? Even if you use the 50%
    of intrinsic value method, you still are paying high
    prices for stocks.

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