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How To Profit Off What Buffett Said About Interest Rates

Breaking news – the stock market is doing this.

But you’ve heard it all before.

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So, where to next?

If you take advice from the talking heads on TV, the message is scrambled and unclear.

After all, ratings is the name of the game.

But when Buffett talks, I listen.

Back to the question.

Where does the market go next?

If you judge by price alone, the market looks frothy. However, Buffett looks at valuation and interest rates together to get a bigger picture of where stocks are headed.

Here's what he says:

Valuations make sense with interest rates where they are... In the end, you measure laying out money for an asset in relation to what you’re going to get back, and the number one yardstick is U.S. government [bonds].

Everything in valuation gets back to interest rates.

Nowhere does Buffett use price as an indicator.

On the contrary, Buffett uses the interest rates from bond markets as a yardstick to determine how relatively cheap the stock market is.

Like all things, nothing can exist in a vacuum. Stock markets become cheap or expensive relative to interest rates or what he also refers to as "hurdle rates".

A hurdle rate is the lowest acceptable desired rate of return on your investment.

If yields are at 2%, I doubt anyone would be satisfied with 2% returns from the stock market.

It's such an important idea that Buffett has said that if there was only one thing he could know about the future, it would be what the 10 year Treasury Yield would be.

Think about that.

It's not the market level, who the president is or what the tax rate it.

It's what the interest rate is.

If rates go up, then market valuation becomes more expensive as the stock market has to justify superior returns relative to risk free rates.

Let's use Apple (AAPL) as an example so that you can see how it all works.

How Interest Rates Affect Apple (AAPL) Valuation

An easy formula to gauge how interest rates affect valuation is to use the Ben Graham formula.

The original formula from Security Analysis is

graham-formula-old

where V is the intrinsic value, EPS is the trailing 12 month EPS, 8.5 is the PE ratio of a stock with 0% growth and g being the growth rate for the next 7-10 years.

However, this formula was later revised as Graham included a required rate of return. Same thing as Buffett's hurdle rate.

graham-formula-update

The formula is essentially the same except the number 4.4 is what Graham determined to be his minimum required rate of return.

At the time of around 1962 when Graham was publicizing his works, the risk free interest rate was 4.4%, but to adjust to the present, we divide this number by today’s AAA corporate bond rate, represented by Y in the formula above.

To show you how interest rates affect valuation, we'll calculate two values.

One using today's 20 year AAA corporate bond rate of 2.85%, and another using today's 20 year A grade corp bond rate of 4.1%.

Let's see how they compare.

Here is the valuation for the 20 year AAA yield using Graham's formula using Old School Value to simplify the process.

What Buffett Said About Interest Rates

When the 20 year AAA yield is used, AAPL's fair value comes out to $264. Compared to the current stock price, the margin of safety is 40%.

In other words, low rates make stocks cheap.

Re-run the valuation with the 20 year A rate of 4.1% and it now looks like this.

The difference in interest rate has caused the valuation to drop to $183 with a smaller margin of safety of 14%.

Ignore interest rates completely and you'll buy high or miss opportunities.

The Most Important Thing

At the end of the day, it all comes down to buying low and selling high.

Making a profit.

But how do you know when to buy without knowing the value of a stock?

On the Old School Value valuation dashboard, we use 3 valuation models to give you different valuation angles.

Graham's Formula uses earnings and interest rates to give an approximate value based on current market conditions.

We take Buffett's advice and use a 3 stage DCF to value the business based on future cash flows.

An EBIT multiples is also used as a relative valuation model.

Taking this 3 pronged approach provides for a better valuation range.

Here's how AAPL looks right now.

Based on the three valuation models (DCF, Graham's Formula, EBIT multiples), the average fair value is $186 with a 16% margin of safety vs the stock price of $157.

Depending on your risk profile, an 16% margin of safety may be too little or just right.

But what you see is a range of "what if" scenarios that can take place from $165 to $211.

Based on my current assumptions, my thoughts on AAPL is that it is not overvalued at current prices despite how much the stock has gone up.

How to Find Undervalued Stocks

Because searching for undervalued stocks take a lot of time, the process is easier with the OSV screener which includes valuation and margin of safety filters.

Here's a sneak peek at how I have mine set up.

Margin of Safety Screening Filters
Margin of Safety Screening Filters

I'm looking for stocks that have a margin of safety between 15% and 50% for the DCF variations and Graham Formula valuation.

By doing so, the universe is immediately filtered to stocks that live inside the "reasonable" to "cheap" valuation range.

Here are the top 10 results.

Based on these top 10 results, I see that the auto industry can either be cheap or value. Something to look into but the great part is I did not need to spend an hour to find a cheap industry to look through.

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Article by Jae Jun, Old School Value