Stock market jitters and investment finance

Citation

Robinson, B. (2002), "Stock market jitters and investment finance", Balance Sheet, Vol. 10 No. 4. https://doi.org/10.1108/bs.2002.26510dab.001

Stock market jitters and investment finance

Bill Robinson is Head UK Business Economist in Financial Advisory Services at PricewaterhouseCoopers. He is a former Special Adviser to the Chancellor of the Exchequer.

A salient feature of the economic environment at present is that the stock market appears to be in worse shape than the real economy. Why has that happened, and what are the implications for business planning?

The conventional wisdom amongst the macro economic forecasting community is that after a downturn that has proved relatively mild (at least compared with the major recessions of 1980 and 1990) recovery is on the way. Policy makers appear to have done a good job of limiting the downswing by supportive fiscal and monetary policy. Government spending has grown faster than GDP, as it should when private demand is weak. Consumer confidence has held up remarkably well throughout the recession, and spending is being sustained by low interest rates. Under these conditions, we might have expected businesses to take advantage of low borrowing costs to re-launch stalled investment projects, adding new momentum to the recovery. But that scenario looks less likely following the major hiccup in the stock market. Business confidence, according to survey evidence, was recovering but still fragile. Will it now follow the real economy upwards or the stock market downwards, delaying or aborting the recovery?

The stock market fall is justified by fundamentals

To answer that we need to understand why stock markets have fallen. The obvious cause is the wave of accounting scandals in large companies. They matter because equities represent a stake in present and future profits. If the profits are lower than they were thought to be, it follows that shares are less valuable. So it is no surprise that the share price of

the tainted companies has fallen. Their collapse has had wider repercussions, and the market as a whole is depressed, because of the possibility that there are more scandals still to emerge.

However there is another, more worrying, explanation of stock market weakness. The long stock market boom of the 1990s carried share prices to ever-greater multiples of earnings. The earnings multiple is a convenient short-hand, which wraps up two key determinants of value:

1. 1.

   the rate at which earnings are expected to grow; and

2. 2.

   the discount rate to be applied to future earnings.

High multiples imply rapid growth of future profits, and/or a low discount rate. Multiples are very sensitive to small changes in expected growth and in the equity risk premium (which determines the rate at which future profit streams are discounted).

For example, if a share stands on a multiple of 40, that is consistent with an expected nominal growth rate of profits of 6.5 percent per annum, discounted at 9 per cent. If the same share stands on a multiple of 20 that could imply an expected growth rate of profits of 5 percent per annum discounted at 10 per cent. Both sets of numbers look eminently reasonable. But if the multiple moves from 40 to 20, share values halve. That is a dramatic change, and it is worth looking more closely at the calculations which suggest that such a change is reasonable.

The future for profit growth

Consider first the growth expectations. If inflation is expected to remain at around 2.5 per cent, a fall in nominal profits growth from 6.5 percent to 5 percent implies a fall in expected real growth of profits from 4 per cent to 2.5 per cent. The latter figure is in line with the long-term growth of real incomes in a mature economy. Over the medium term, profits are a stable share of national income, implying that real profits grow in line with real GDP at 2.5 percent per annum. The 4 per cent figure is bullish, but not ridiculous. It may have been widely believed in the late 1990s when the US economy was talked up as having established a new growth paradigm. But the balance of probability is that 2.5 percent growth of profits is more likely than 4 percent over the medium term.

Then consider the appropriate discount rate for a stream of equity profits – the cost of equity. The standard calculation of the cost of equity begins from a risk free rate of 2.5 per cent, adds inflation (again 2.5 per cent) and then adds the equity risk premium. A standard market estimate of the risk premium is 4 per cent, giving a discount rate for equity returns of 9 per cent. However, a case is often made for much higher numbers. So a risk premium of 5 per cent, in the post September 11, post-Enron world does not seem unreasonable, implying a discount rate of 10 per cent.

The frightening conclusion from this analysis is that a downward revision of 1.5 per cent in the expected growth of earnings, together with an upward revision of 1 per cent in the equity risk premium, halves the value of equities. The implication of this analysis is that the recent falls in the market are not an aberration, shortly to be corrected, but could be a return of share values to levels that are more soundly underpinned by the fundamentals.

Implications for company finance

However, the key conclusion is not that share values might have some way still to fall. Rather, the above analysis shows that nobody can be very sure at what level any share is correctly valued. And this means that new share issues are unlikely to be the financing method of choice for companies seeking to expand. It turns out that there is nothing very new about that, at least in the UK, as Figure 1 shows.

Figure 1 Capital issues by UK industrial and commercial companies (£ billions)

The popularity of bonds

Since the mid-1990s UK companies have consistently preferred to issue bonds rather than equity to finance the gap between their spending needs and their retained profits. (Retained profits are usually the first-choice source of funding.) One reason for this is that as inflation has fallen and stabilised, the real value of bonds has become reasonably predictable, to both buyers and issuers. Another is that the change to corporation tax in 1997 made bonds a much more tax efficient source of finance, particularly for companies offering high yields rather than capital growth.

"The real value of bonds has become reasonably predictable"

The tax advantages of debt are not about to disappear, and nobody is expecting a resurgence of inflation. So bonds remain a predictable store of value, while equities have become extremely unpredictable. Pricing new equity issues in the current market is not an easy task. For that reason, if the recovery of the real economy survives the current spate of stock market jitters, it will make sense for companies to use the bond market, more than the equity market, to finance their expansion plans.

The resurgence of the bond finance that was such a remarkable feature of the 1990s has been halted by the shocks that have hit financial markets over the past year. But if the economic recovery remains on course, despite the financial turbulence, expect bonds to remain the favoured source of new finance.