This year taught us that income investors cannot afford to ignore the economic backdrop
Once we grasp this connection we can see how important the economic background becomes to investors and why we ignore it at our peril, even if in an ideal world we would love to own “all-weather” investments that will perform for us no matter what happens in the wider world.
So what is discounted cash flow and how do we use it? We will try to avoid a technical explanation and instead pose this question: how much would you pay now to receive a guaranteed £1 in a year’s time?
It would not make much sense to pay £1, because money available to you to spend right now has to be better than money that becomes available to spend only later. But how about 99p? Would you be prepared to wait a year for that increase in value of just over 1pc? Or would you need to be able to pay just 95p, or 90p, or 80p now for that £1 in a year’s time to make the offer appealing?
Questor cannot imagine anyone making that decision without reference to interest rates or inflation. Think about one of those scenarios, the chance to pay 90p now for £1 in a year’s time. In an era of zero inflation it would be an astonishingly attractive offer: you would be receiving an 11pc gain on your money at the cost only of waiting a year, because each penny of the money you receive then would have the same buying power as your money now.
But if inflation were 20pc you would look at it differently. You would say to yourself: by the time I can spend my money, it will have lost a fifth of its buying power, and a rise in its nominal value of 11pc from 90p to £1 will not be enough to offset it. So I would rather keep hold of my £1 now so that I can spend it while it has its current buying power, not wait a year and see its real value diminished.
The discounted cash flow method of valuation simply takes this idea and says: how much would you pay now for the money (dividends or capital returns of any form) that a given investment will deliver to you in future? Put another way, it tells you the present value of all the cash you can expect the investment to deliver to you in future; hence the expression you’ll sometimes hear of “net present value”.
As we have seen, your expectations of inflation are at the heart of this valuation method. The financial markets, complex though they are, in essence apply this logic when they value investments of all types. In a nutshell, this is why we have seen the dramatic swings in prices this year.
Rises in inflation and interest rates do not automatically mean that we just have to accept that all our investments will fall in value, however.
While the discounted cash flow method says that the present value of a fixed future return will fall, the damage is undone if the cash flows we expect in future can rise in response to rises in inflation and interest rates.
The assets where this simply cannot happen are conventional bonds, so their prices have fallen across the board. Index-linked bonds are different, although even here prices have fallen because they had arguably been overbought earlier.
When it comes to investments in property and shares, much depends on the risk of recession; if economic growth can be maintained, it is reasonable to expect rents to rise in an inflationary environment and for companies to be able to pass on rising costs to their customers.
This is why our Income Portfolio contains a mix of assets.
Our bonds will at least pay their contracted income even in a recession, while our property funds and stock market investments offer the scope to produce rising dividends once the economy recovers.
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