Fed Needs To Focus On Interest Rates, Not Valuations

Federal Reserve not equipped to do valuation assessments

Janet Yellen, Federal Reserve Chair, indicated that valuations in social media and biotechnology “appeared substantially stretched” in her July 15 testimony to Congress. Aswath Damodaran, professor of finance at the Stern School of Business at NYU and author of numerous valuation focused books, believes that the Federal Reserve is not equipped to value stocks.

Damodaran points out that the Fed has not explained the reasons behind its social media price assessments. He concedes that the nascent sector may be overpriced as investors tend to assign value based on market and user base growth potential, which is often overestimated. The market cannot accommodate all new or existing entrants. Facebook Inc (NASDAQ:FB) was priced too high at the time of its initial public offering, according to Damodaran. He thought the stock was inexpensive when the market overreacted to negative news regarding earnings. After price recovered, Damodaran took profits on the stock. Regarding Twitter Inc (NYSE:TWTR), Damodaran continues to have doubts about whether

Twitter’s restricted reach advertising model will allow sponsors to reach Twitter’s users and profit from product sales. Given that traditional measures to determine value such as price/earnings (P/E), earnings before interest, taxes, depreciation and amortization (EBITDA) or forecasts of revenue streams do not work in assessing value of social media names, investors have to resort to number of users at each social media firm and determine their value. Damodaran attempts to determine user value by forecasting revenues from online advertising for 2023 at some social media companies. He uses online advertising revenue share percentages indicated in annual reports and inputs revenues required for companies to have break even cash flows in 2023. Damodaran’s estimate of $319.2 billion of online advertising revenue exceeds the estimated size of the online advertising market in 2023 of $303.04 billion. It appears that investors are indeed overestimating the size of online advertising revenues with social media sector.

Source: Aswath Damodaran Musings on Markets blog; October 14, 2013

Within social media, however, there may be a few companies that will succeed in capturing users and monetizing their traffic. If one invests in an individual firm such as Facebook Inc (NASDAQ:FB), Twitter Inc (NYSE:TWTR) or LinkedIn Corp (NYSE:LNKD) that turns out capturing market share and being profitable, one may realize outsized returns relative to the overall social media sector. Predicting prices for biotechnology enterprises is even more difficult as success depends on drugs being approved by the FDA and their corresponding commercial potential. In Damodaran’s view, the challenge is to find underpriced companies even in sectors that may be overbought.

Federal Reserve: Lower rates push up prices of all assets

Damodaran contends that the Federal Reserve does affect interest rates at the margin, keeping them at levels in line with economic growth, labor conditions, and inflation. Rates have been low for the past five years as the economy has struggled to recover growth rates to reach pre-crisis levels. Low rates drive asset price gains by increasing cash flow projections. High growth sectors like social media and biotech may experience faster asset price gains as their future long term cash flow estimates are inflated by lower rates.

Damodaran agrees with Yellen regarding metrics sending mixed messages on market valuations. The implied equity risk premium (ERP) is at around 5%, which is high by historical standards. At first glance, the ERP does not signal overvaluation. However, ERP has expanded not because stock returns have improved but because the risk free rate has declined. If risk free rates revert to pre-2008 levels, around 4%, and stock returns remain constant, the ERP will indicate overvaluation. If the Federal Reserve is truly concerned about market bubbles, it should stop quantitative easing and let interest rates reach levels commensurate with economic conditions.