Effective Discount Rate or the Reciprocal of the Trailing P/E

[Scot Griffin]

I was going through Blair’s The Ritual of Capitalization article, and I realized his equation for the effective discount rate is the reciprocal of the trailing P/E ratio, i.e., it is the railing E/P ratio.  Whether you divide trailing earnings by market cap, or you divide trailing EPS by share price, you get the same thing.

While this equation is generally correct for an investment over a single period, e.g., a one year loan with a single payment at the end, does it actually fit within and advance CasP’s analytical framing? Another way of asking the question is, while CasP’s simplified discounting equation (aka the capitalization equation) is useful pedagogically, is it useful analytically?  If capitalists look to the future, why would they use a trailing P/E ratio to do that? Do similar P/E ratios imply similar rates of return (aka discount rates)? (Compare, e.g., WMT and NVDA.)  Is there a meaningful correlation between rates of return and trailing E/P ratios?  If capitalists seek to beat the market average rate of return, which has been around 12% annualized over the last 10 years, why would they invest in AMZN or AAPL, with discount rates (aka rates of return) of 1.3% and 2.7%, respectively, as of the time Blair wrote the article?  Does using the simplified capitalization equation to derive an “effective discount rate” tell us anything about the rate of return that capitalists seek and crave?  Does it tell us anything about differential power, for example? (For example, if two companies have similar E/P ratios, similar market caps, but wildly different annualized rates of return, what does that imply?  Different growth expectations? Different hype?)

One of the things about CasP that appeals to me is that it claims to center capitalism in finance, which is what I’ve believed it to be for quite some time.  Although I previously thought about capitalism in terms of compounding, discounting is the inverse function, and the rate r must be (and are) the same for the two functions to be reversible.  From that perspective, CasP rightly focuses on the premium capitalists seek, whether as profits, interest, or yield.

Unfortunately, CasP tends not to explore how financial analysis is actually done.  For example, investors and financial analysts use CAPM (which is discussed in Capital as Power) along with other methodologies to develop free cash flow models.  The primary use of CAPM is to derive a “differential” rate of return relative to the market broadly based on the capital structure of the firm in question.  In some cases, the target rate of return for the equity component of firm(e.g., INTC) is significantly less than the SP500’s rate, sometimes it is greater (e.g., TSLA).  The discount rate actually used in the model typically is the weighted average cost of capital (WACC), which weights the relative contributions and expectations of debt and equity to form a composite discount rate.  Future growth calculations are done separately, and the discount rate (WACC) is applied to the predicted future earnings to reduce them to a net present value.  Here is a good place to get a sense of how these models are constructed.

Despite the foregoing, I still hold out some hope that the effective discount rate analysis may be useful at the macro level, but I don’t have access to the necessary data (or if I do, I don’t know how to find it easily).  One thing I was trying to do was to determine if there is any correlation between P/E ratio (or E/P ratio) and annualized rate of return of the SP500, but I could not find data expressing both on the same scale and fully aligned (e.g., monthly data for P/E ratios, annual data for rates of return, but not on the same dates).

 

Topic

[Jonathan Nitzan]

Scot,

You ask many questions, but it isn’t always clear why.

Obviously, capitalization/discounting/compounding can be made as complicated as you like, but in my mind, the purpose of analysis is to achieve the very opposite — i.e., to simplify. How much to simplify depends on the concrete subject of analysis, which you are yet to specify.

1. Regarding discounting with current known earnings as opposed to expected future earnings. In our 2009 book Capital as Power and later in our 2016 ‘CasP Model of the Stock Market‘, we showed that, over the very long haul, capitalization is tightly correlated with current earnings. This tight correlation is shown in the top panel of this U.S. figure from our ‘CasP Model’.

However, the bottom panel of the chart demonstrates that, over the short run (one year), the correlation between current earnings and capitalized values varies greatly, ranging between +0.6 and -0.2. In other words, in the shorter run, capitalists are very shifty.

2. What causes these changes in the impact of current earnings on capitalization? Our tentative answer was that these shifts depend on the extent of capitalized power (relative to workers): the more powerful/weaker the capitalists, the greater/smaller the correlation. The validity of this claim is shown by the chart below, which correlates capitalized power with the short-term correlation between current earnings and capitalization (taken from the previous chart).

In our work, we speculated that power is bounded. In our view, this bound means that the greater the power, the more frightened capitalists become about their ability to sustain it, and therefore the greater their reliance on visible earnings here and now when capitalizing the future. This is why we labeled the short-term earnings correlation with capitalization the ‘Systemic Fear Index’. (For more on these issues, see Baines and Hager (2020), McMahon (2021) and the work by Fix (2021) that you cite.)

3. On the extent to which capitalists must peer into the future to capture the bulk of their earnings from here to eternity, see our ‘Capitalist Degree of Immortality’ (2021). The chart below shows these computations for various levels of (r–g), where r is the discount rate and g is the geometric long-term growth rate of earnings. It turns out that, under rather normal condition, the capitalist gaze doesn’t have to extend beyond a few dozen years….

 

[Scot Griffin]

Jonathan Nitzan wrote:

Scot, You ask many questions, but it isn’t always clear why.

Jonathan,

In this particular case, it is not because I was looking forward to a lazy, petulant insult or a lengthy, non-responsive, and deflectionary response, but I have come to expect such from time to time, and that is a price I am willing to pay to participate in this forum.

You are not the only person who reads or posts to the forum.  I ask many questions, some of which are the same question phrased differently, with hopes of stimulating thought and engagement regardless of the reader’s background or view of CasP.  In this particular case, I was also engaged in a bit of open brainstorming  while attempting to hedge against potentially reflexive responses.  Who knows, I might even have been successful in my hedging but for leaving in one rhetorical question, a total softball about capitalists being forward-looking, which it the only question you actually sought to answer (see your 3.)

Here is how I interpret your response:

1. The effective discount rate is, indeed, the reciprocal of the trailing P/E ratio. There is nothing particularly inventive or insightful about it.  For that reason alone, I question its value to CasP even pedagogically.
2. The effective discount rate has no value to CasP analytically because it cannot be correlated to the expected rates of return and, by definition, they must be identical.  If they could be correlated, they would be correlated, but they have not been, and the data you adduce in 1. and 2. don’t contradict that conclusion (which is why I find them to be a non-responsive deflection).
3. The effective discount rate potentially undermines the validity of CasP itself because it seeks to do more than it is capable of doing, thereby creating a credible avenue for attacking CasP’s foundational explanation of capitalization.  You shouldn’t make weak arguments if they undermine your stronger arguments. Your response in 1. and 2. lead me to believe that you have no particular desire to shore up the weakness of the effective discount rate, so I would just drop it and pretend it never happened.

Some direct responses to some of your enumerated points:

1. It is no surprise that capitalization is correlated with current earnings because every free cash flow model starts with the previous quarter as the baseline for future growth.  You know that, and using 12-month (4 quarter) trailing averages likely only enhances the correlation as models are adjusted on a quarterly basis (which you also know).  In any event, comparing price to EPS tells us nothing directly about discount rates or expected rates of return.
2. Neither the Power Index nor the Systemic Fear Index tells us anything about discount rates or expected rates of return.
3. I am happy that you found a way to talk about rates of return, but the discussion is a bit of a non sequitur (and it would have been a complete non-sequitur but for my inclusion of that one rhetorical question; you’re welcome).

Unless CasP embraces, adapts, and enhances financial analytical tools to suit its needs, I don’t think it can evolve from the niche theorem/axiom it is today into a useful, explanatory theory.  Endless, repetitive proofs that capital is power don’t advance anything, and it is not enough to go against the economic orthodoxy, you have to do the same against the financial orthodoxy, only more so.

 

 

 

 

[Blair Fix]

Scot Griffin wrote:

The effective discount rate is, indeed, the reciprocal of the trailing P/E ratio. There is nothing particularly inventive or insightful about it. For that reason alone, I question its value to CasP even pedagogically.

I’m not sure I follow this logic. Yes, what I call the ‘effective discount rate’, is the inverse of the trailing P/E ratio. But I don’t follow how this means there is nothing insightful about it. What is interesting is that capitalist agree to capitalize by relating prices to earnings. There is no objective reason they must do so. It is an ideological choice.

Now, educated capitalists know that they should care about price-earnings ratios. So my analysis doesn’t tell them anything new. But that’s not the point. As I see it, what CasP does is similar to what anthropologists do when they study foreign cultures. These cultures clearly know what they believe — for example that a king’s power stems from god — but the anthropologist looks at this ideology from a structural perspective, rather than simply accepting it as ‘the way things are’.

Scot Griffin wrote:

The effective discount rate has no value to CasP analytically because it cannot be correlated to the expected rates of return and, by definition, they must be identical. If they could be correlated, they would be correlated, but they have not been, and the data you adduce in 1. and 2. don’t contradict that conclusion (which is why I find them to be a non-responsive deflection).

I think the main argument, in CasP, is that capitalist claim to look to the future, but in practice, look to the past. So there is a herd behavior where capitalists agree — with varying degrees of uniformity — that future earnings will be similar to the recent past.

Of course, this belief system is a rich topic for inquiry that needs a lot more research. For example, I’d like to see sociologists get involved and do qualitative analysis of capitalist’s actual expectations. It would be interesting to see how these beliefs relate to the things like the systemic fear index.

My reading of your comments is that there is much more research to be done. If a capitalist claims to be using capitalization formula x, then we should take them at their word and study how this formula is applied.

To wrap things up, I think what Jonathan is getting at is that capital as power research starts with a very general hypothesis (capitalization is an act of power), but then typically asks very specific empirical questions. Speaking for myself, I find your comments quite interesting. But perhaps you could simplify them into specific research questions that we might answer with data.

• This reply was modified 1 year, 12 months ago by Blair Fix.

[jmc]

Scot Griffin wrote:

In any event, comparing price to EPS tells us nothing directly about discount rates or expected rates of return. Neither the Power Index nor the Systemic Fear Index tells us anything about discount rates or expected rates of return. I am happy that you found a way to talk about rates of return, but the discussion is a bit of a non sequitur (and it would have been a complete non-sequitur but for my inclusion of that one rhetorical question; you’re welcome).

What can you show us about rates of return? And if you lack the evidence, what do you need in order to show us? Aside from analytical proofs, which we are already debating in other threads, is there any empirical example that can help us the see problem that needs more investigation?

I’m starting to feel that you hope that CasP research gets redirected into what you call financial analysis, but the funny thing is, I don’t think anyone disagrees if the issue is that we, collectively, need to keep expanding CasP theory. Rather you (or someone) needs to give us an empirical example to collectively stew over.

[Scot Griffin]

jmc wrote:

What can you show us about rates of return? And if you lack the evidence, what do you need in order to show us?

Annualized rates of return are available for every publicly traded stock and the SP500, generally.  See, for example, the SP500 website and click on any of the “1 Year”, “3 Year”, and “5 Year” tabs above the chart, for example.  You can also go to a basic finance website and compare graphically relative rates of returns.  Here is a 10 year chart at Yahoo Finance comparing nVidia and Walmart, two companies with similar P/E ratios, against the SP500.

Even if a particular stock does not have the annualized return readily available, it can be computed using annual price and dividend data, which is a subset of the information used in CAPM analysis to develop the target rate of return relative to the SP500.  Such information has been available in 10-Ks for awhile now, as well, because companies compare their returns to their peers as part of the prep for annual shareholders meetings.

Aside from analytical proofs, which we are already debating in other threads, is there any empirical example that can help us the see problem that needs more investigation?

I think the Yahoo Finance link, above, illustrates my concern, but here is some potentially useful information:

As of today, NVIDIA has a trailing P/E of 40.78 and a market cap of $378.9M with estimated 2022 profits of $8.0B on $28.6B of revenue.

By comparison, Walmart has a trailing P/E of 44.24 and a market cap of $387B with estimated 2022 profits of $9.0B on $600B of revenue. (Yes, that is 1.125x NVIDIA’s profit with 20.979x NVIDIA’s revenue.)

According to Fortune magazine, the 2022, 5-year annualized, and 10-year annualized rates of return for NVIDA were 125.5%, 62%, and 57.3%, respectively.  The same rates of return for Walmart were 1.9%, 18.3%, and 11.3%, respectively.

The effective discount rates of NVIDIA and Walmart are 2.45% and 2.26%, respectively.  Leaving aside that the discount rate and rate of return for any given stock refer to the same quantity, the rates of return for the two companies are vastly dissimilar despite the fact their effective rates of return are nearly the same (they were closer a couple of days ago).  It seems to me that, whatever the reciprocal of the P/E ratio shows us, it is not the rate of return (discount rate), effective or otherwise.

I suspect that there are at least two problems with using the reciprocal P/E as an indicator of discount rate.  First, it does not account for different capital structures (the mix of debt and equity), which affects WACC, the discount rate used in free cash flow models.  For example, Stock-Analysis -on.net has calculated the WACC of Walmart and NVIDIA to be 7.74% and 15.82%, respectively, using an expected rate of return of the market of 12.45% and a risk-free rate of 3.88%.  Second, the reciprocal P/E provides no direct information of expected growth of future earnings.  Stock-Analysis -on.net has calculated future earnings for NVIDIA and Walmart of $460B and $384B, respectively.  Before accounting for debt obligations, a simple rollup of the next five years of cash flow plus terminal value was within $40B.

I’m starting to feel that you hope that CasP research gets redirected into what you call financial analysis, but the funny thing is, I don’t think anyone disagrees if the issue is that we, collectively, need to keep expanding CasP theory. Rather you (or someone) needs to give us an empirical example to collectively stew over.

I hope the above helps.  There are at least three reasons why I think it would be useful for CasP researchers to be conversant with financial analysis and high finance thinking.  First, if capital is finance, you need financial tools to study it.  Second, CasP researchers need to be able to speak to financial types as they speak with each other, both to cultivate a valuable resource, and to avoid potential misunderstandings that might affect credibility.  Finally, understanding how financial instruments are structured and measured by capitalists themselves ought to yield deeper insights and set CasP researchers on the path towards having policy discussions and making policy proposals.  Proving yet again that capital is power can only get you so far.

Water is wet. Capital is power. Knowing those two things does not suggest that anything needs to be done–or can be done– about either of them.

[Scot Griffin]

Blair Fix wrote:

Scot Griffin wrote:

The effective discount rate is, indeed, the reciprocal of the trailing P/E ratio. There is nothing particularly inventive or insightful about it. For that reason alone, I question its value to CasP even pedagogically.

I’m not sure I follow this logic. Yes, what I call the ‘effective discount rate’, is the inverse of the trailing P/E ratio. But I don’t follow how this means there is nothing insightful about it. What is interesting is that capitalist agree to capitalize by relating prices to earnings. There is no objective reason they must do so. It is an ideological choice. Now, educated capitalists know that they should care about price-earnings ratios. So my analysis doesn’t tell them anything new. But that’s not the point. As I see it, what CasP does is similar to what anthropologists do when they study foreign cultures. These cultures clearly know what they believe — for example that a king’s power stems from god — but the anthropologist looks at this ideology from a structural perspective, rather than simply accepting it as ‘the way things are’.

If you avoid applying the reciprocal P/E ratio to individual stocks, there might still be value in it.  The problem is CasP’s capitalization formula is simplified to such a great extent that it is best used making broad brush strokes.  It is not suitable for filling in fine details. See my response to JCM as it relates to companies with similar P/E ratios and vastly different rates of return.

The problem with calling the reciprocal of the P/E ratio a discount rate in any situation is that it demonstrates complete ignorance of what the natives actually think and believe.  They know what a discount rate is and how it is used, and they know the P/E ratio doesn’t tell you anything about it.  If you want to use reciprocal P/E to make a point, call it something else

Scot Griffin wrote:

The effective discount rate has no value to CasP analytically because it cannot be correlated to the expected rates of return and, by definition, they must be identical. If they could be correlated, they would be correlated, but they have not been, and the data you adduce in 1. and 2. don’t contradict that conclusion (which is why I find them to be a non-responsive deflection).

I think the main argument, in CasP, is that capitalist claim to look to the future, but in practice, look to the past. So there is a herd behavior where capitalists agree — with varying degrees of uniformity — that future earnings will be similar to the recent past. Of course, this belief system is a rich topic for inquiry that needs a lot more research. For example, I’d like to see sociologists get involved and do qualitative analysis of capitalist’s actual expectations. It would be interesting to see how these beliefs relate to the things like the systemic fear index. My reading of your comments is that there is much more research to be done. If a capitalist claims to be using capitalization formula x, then we should take them at their word and study how this formula is applied. To wrap things up, I think what Jonathan is getting at is that capital as power research starts with a very general hypothesis (capitalization is an act of power), but then typically asks very specific empirical questions. Speaking for myself, I find your comments quite interesting. But perhaps you could simplify them into specific research questions that we might answer with data.

I understand that you believe the data you have seen show capitalists really look to the past, not to the future, but are there are other data out there that might lead you to change your opinion? For example, have you spent any time with actual free cash flow models and how they project future free cash flows and terminal values to determine the current intrinsic value of a stock based purely on those projected cash flows (other than using the free cash flow of the prior year as the baseline from which growth is projected)?

I spent time earlier this year tearing apart Stock-Analysis-on.net’s free cash flow analysis methodology, and I have their free cash flow models for several companies in Excel files.  It shouldn’t take me along to finish the summary of method document, and I would be happy to share that and some of the data via Dropbox or Google Drive. (I will confirm with the owner of the site that he is okay with my sharing with researchers.)  Just let me know.

[Jonathan Nitzan]

Thank you for your replies, Scot.

Questions drive thinking, so I thought it was clear that, in saying that you asked many questions but that it wasn’t always clear why, I didn’t criticize you for asking them. I simply meant that I, personally, didn’t understand the reason behind them.

Let me try to clarify my thinking here.

1.

As I see it, the rate of return at any point in time is a backward-looking straightforward computation of the rate of change of the asset’s price (or total return, as the case may be).

By contrast, the discount rate at which future earnings are capitalized to give an asset its price is a much more slippery forward-looking construct. In my work with Shimshon, we suggested two things: (1) that in the mind of capitalists this rate is the product of a ‘normal rate’ common to all investments and a ‘risk coefficient’ unique to the asset in question; and (2) that both quanta vary over time and across investors and can be known only by asking them (finance manuals don’t count here, since investors are free to ignore them).

With this conceptual difference in mind, the rate of return and the discount rate will be the same only by fluke.

2.

The positive long-term U.S. correlation between stock prices and trailing earnings shown in Figure 7 of our ‘CasP Model of the Stock Market’ is backward-looking and therefore cannot tell us how capitalists set asset prices looking forward.

3.

Contrary to your interpretation, we – Bichler and I – do not argue that the trailing E/P ratio is the effective discount rate. Our claim, rather, is that capitalists change the earnings they discount depending on their power relative to workers and their systemic fear. When capitalists are less powerful and more confident, they follow their dominant ritual and tend to discount expected future earnings; when they are more powerful and less confident, they tend to abandon this ritual and discount trailing earrings. The purpose of the bottom panel of Figure 7 and of Figure 9 in our ‘CasP Model of the Stock Market’ was to substantiate this proposition.

4.

Firms with similar backward-looking data can be priced differently – and yield different rates of return — because forward-looking capitalization pretends to see a future that isn’t necessarily the same as the past.

5.

You seem to suggest that finance is somehow separate from and perhaps more important than economics, and maybe you are right. In our view, though, they are not separate but integrated. I think we agree that to understand capitalism we must understand finance, among other things (in our case, because finance is the main architecture of capitalized power). But in our opinion, finance has no theoretical underpinnings of its own. Complex as it may look in practice, finance is a ritualistic derivative of mainstream economic reasoning (or, as an erudite late friend of mine once bluntly opined, ‘it’s not even a “branch of knowledge”’.)

6.

You argue that saying that ‘capital is power’ is ineffective as saying that ‘water is wet’. Somehow, I doubt you really mean it. Researching and demonstrating the ways in which capital is power helps undermine prevailing political-economy and create a new way of understanding and resisting capitalism. The fact that we personally seldom engage in ‘policy recommendations’ is because, at this point, we don’t feel there is anyone to recommend policies to. But you and others are more than welcome to do so.

• This reply was modified 1 year, 12 months ago by Jonathan Nitzan.
• This reply was modified 1 year, 12 months ago by Jonathan Nitzan.

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