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# Re: Mental Models-Financial Assets As Levers.

### It feels like the markets are about to encounter a major regime shift, so I thought I would write about how I think about valuation frameworks in terms of LEVERS.

The other day, this Musing invited some questions:

Let’s briefly go back to business school and touch on the basic DCF (Discounted Cash Flow) equation, where i = interest rate, CF = cash flow for period n, TV = terminal value at end of term t:

In plain English, “the present value of a financial asset = the summation of cash flows discounted by i + the discounted value of the terminal value.”

This is a financial truism, IRRESPECTIVE of the asset class. Not surprisingly, BONDS are valued this way:

STOCKS and BUSINESSES are valued this way:

All of these formulas are basically the same and can be thought of as the same 2 components: 1) Cash Flows (in the near/medium-term) + 2) Terminal Value (way down the line).

Let’s pivot (pun intended) to levers (technically first-class levers) for a second.

It should be fairly intuitive that as you move the fulcrum to the right towards the source of “Load” that you gain a “mechanical advantage” and can apply less “Effort” to lift the same “Load.” The converse is also true: shifting fulcrum to the left loses mechanical advantage.

Applying this model to financial valuation, think of interest rates (really discount rates) as the “Effort” that can impact the valuation “Load” and think of the fulcrum point as the relative mix of “Cash Flow” term vs. “Terminal Value” term of the DCF equation.

KEY IDEA: A financial asset whose valuation derives principally from the Terminal Value is like a 1st class lever whose fulcrum point is close to the Load. In other words, it takes very little movement in the interest rate “Effort” to move the valuation “Load” A LOT.

Digression: Why do pundits/analysts in the media almost never use the DCF framework? Because it requires WORK! Multiples analyses (PE multiples, EBITDA multiples, CF multiples, Revenue multiples, Cap Rates) are all “lazy” heuristics that apply the “80/20” rule to valuation.

The degrees of “lazy” vary with the heuristic. For instance, to just slap a revenue multiple on a business tells you very little about what ULTIMATELY matters: earnings and cash flow. Also: what growth rates do you assume? What’s the right forecast horizon? What discount rates?

In the end, however, what all of these heuristics have in common is that they try to estimate the valuation by slapping a quick & dirty multiple of current flow (earnings, cash flow, revenue, NOI, etc.) and then also discount a Terminal Value term. End of digression.

The underlying DRIVERS of valuation are the same, which is why it’s important to understand the conceptual framework underlying all of these methods.

This brings me back to my original Musing regarding thinking about “stocks as bonds,” why “duration of CFs” matter, and why many tech stocks resemble “30-year zero-coupon bonds” – and MOST IMPORTANTLY: how even a small shift in rate expectations can move valuations A LOT.

In my lever analogy, long-dated zero-coupon bonds & tech stocks whose valuations derive from terminal values far in the future resemble 1st class levers with large mechanical advantages, where even a small shift in the interest rate “Effort” can move the valuation “Load” A LOT.

What is exceptionally worrisome about today’s markets is that so many asset classes fall into this bucket. As bad as overvalued tech stocks are, at least one can argue that there is still an underlying valuation framework that’s applicable.

Can you even say that a DCF valuation framework is applicable to the world of crypto for the most part? The lack of intellectual rigor in valuation methodology + “new paradigm” talk of why “traditional valuation” methods no longer apply really bother me.

At least with the B2B Bubble of 2000, there was a still an underlying valuation framework, albeit tainted by GIGO. In so many asset classes today, there is not even that.

I’ll end it here. Let the arrows fly.

There is more richness to this mental model that I forgot to add: the concept of DURATION. Begin. Part II.

One of the more memorable HF interview questions I got coming out of b-school was: “Motivate and derive the formula for bond duration.” Sounds more intimidating than it actually is.

Mathematically, DURATION is basically the first derivative of the bond equation (which is just the polynomial mentioned above) with respect to i. Conceptually, it is the bond’s sensitivity to interest rates, often denoted by Greek letter RHO.

Applied to the lever analogy, DURATION is akin to the MECHANICAL ADVANTAGE of the lever which scales with the length of lever arm between “Effort” and “Fulcrum.”

The longer the lever arm between source of “Effort” and fulcrum the greater the mechanical advantage for lifting the “Load.”

Similarly, the longer the DURATION of the asset, the more sensitive the valuation “Load” is to the interest rate “Effort.”

This is immediately obvious with BONDS but conceptually it is applicable to ANY asset. Remember I said that the fulcrum position represents the mix between the left “Cash Flow term” and the right “Terminal Value” term?

The more an asset’s valuation derives from the “Terminal Value” term, the greater the DURATION, the more sensitive to interest rates.

For STOCKS, the concept of GROWTH vs. VALUE comes to mind. One can argue that GROWTH stocks are more heavily weighted to the “Terminal Value,” while VALUE stocks are more grounded in the “Cash Flow” term.

This is precisely why I say that overvalued tech stocks are like 30-year zero coupon bonds — they both have heavy “Terminal Value” terms, have large DURATIONS, and more sensitive to rate changes.

End. Part II.

## Re: Mental Models-Financial Assets As Levers.

I'm late to reading this post. I followed a link from your post this week.

I'd like to point out that lots of speculative real estate is heavily "terminal value" and not current cash flow. In fact buyers (flippers and speculators) frequently buy negative cash flow properties. This is an extreme duration and highly sensitive to interest rates (as most are financed with 70%+ debt). Doesn't bode well for real estate speculation.

Good article and interesting comparison.

The problem comparing tech stocks to long duration zero coupon bonds is the credit risk factor and the value cap. Credit risk is very high, as some darlings like Yahoo never regained their peak and quite a few like SUN went to zero - but money flocks in because there’s no strict value cap.

Right now, I see an insane amount of negative views on treasuries, which have a solid value cap but zero credit risk. 20 year treasuries are priced to pay a nominal 5.2%. Off-the-run coupons will be lower, but after maturity you get 5.2% nominal plus principal no matter what.

Treasuries are unique in that you are literally buying an income stream, which has a definite intrinsic value. These will not go to zero. I believe that more and more investors are going to be looking at this and asking themselves whether it’s worth risking money in stocks when they can get a safe yield instead.

Most people think of bonds in terms of yields, and the higher rates get and the longer they stay there, the more people will decide to shift 401k’s towards bonds.

The biggest questions for any investor is when will rates top out, and when will they break the stock market.