The stock market has been spooked by rising interest rates. Let’s think carefully, from a value investing standpoint, about these fears. Warren Buffett famously argued that investors should think of stocks as “disguised bonds,” in that stocks pay dividends, analogous to the coupons paid by bonds, and can be valued similarly. Bonds are routinely valued by discounting their coupons and maturation value by a term structure of interest rates.
It would be a mistake to use one interest rate to value bonds with different maturities; for example, to use the same interest rate to value three-month Treasury bills
TMUBMUSD03M,
3.267%
and 30-year Treasury bonds
TMUBMUSD30Y,
3.776%.
It would also be a mistake to use a single interest rate to value bonds with different coupon rates; for example, to use the same interest rate to value 20-year Treasurys
TMUBMUSD20Y,
4.093%
with 3% and 5% coupon rates. Bonds should be valued using the full term structure, and knowledgeable investors do so. The exact same logic applies to stocks. John Burr Williams, one of the founders of value investing, wrote that, “A constant rate is wrong, and can only lead to wrong results.” In his classic treatise The Theory of Investment Value, Williams argued that a stock’s intrinsic value should be determined by discounting dividends by a term structure of interest rates (plus risk premia), analogous to the term structure used to discount bonds. A dividend three months from now should be discounted by a three-month rate, a dividend 10-years hence by a 10-year rate. Williams recommended that stock investors who want to use a single interest rate use an extremely long-term interest rate, specifically, the “yield to perpetuity” on Treasury bonds, which is an average of the term structure rates for bonds that never mature. Williams’ arguments for a complete term structure never caught on. Instead, academics and stock investors generally use a single interest rate, typically a short-term rate. For example, finance textbooks authored by Copeland and Westin; Body, Ka …