NPV: spinning the equation in hypothetical deflationary world

In an MBA corporate finance class, the first thing we learn is NPV – Net Present Value.  When I first understood that, it was almost like understanding the whole business world in this simple formula.  For example, a company could do so many things, there would be thousands of moving parts from customers, suppliers, competitors, employees, financiers to goods, loans, machineries… and so on. If you put all that together in one single formula, that is NPV:  the net sum of all present and future cash flows.

One element in this equation is WACC: Weighted Average Cost of Capital. This is the discount factor that you apply to find the value of cashflows each year after discounting the inflation and thus the interest rate.

We all are taught that future cash flows have less value than present cash flow. The underlying assumption is that there is inflation and interest rates are going to increase. Now imagine, just for a second, how the world will be in a deflationary state with interest rates becoming negative and assuming for the heck of it, WACC becomes negative… the future cash flows will become more valuable than present value.  So suddenly, what that means for the investor is that assets are very cheap and produce good returns year on year. So in that sense, Apple shares are not expensive but cheap!!! The stock market is not expensive but cheap. So it is contra argument and we start seeing a different perspective on how assets are valued. In a negative interest world, the farther away the revenue is, the less risky it is.

I have been taking some time and discussing this insight with some of my close MBA classmates. They all kind of see what I am getting at, but it is difficult to fathom and internalize, because it changes the way we see the valuation of assets and the world around us!  🙂 Welcome to a new world of contrarian thinking.

Deflation Export: new Trend

For the last 40-plus years, one major trend that has been sweeping the world is globalization.  People, cities and countries got more and more connected. And the internet kind of put the whole globalization on the fast track.

In terms of economics – if I may simplify – things got cheaper in the developed world, as with globalization, goods started coming from China, finished products started coming from Bangladesh and Pakistan, and information technology professionals started coming from India. Oil was partly regulated by OPEC in terms of exports and matching supply and demand, but nothing was regulating the other industries.  So we saw prices dropping  for most goods the world over. Our shirts, our pants, our shoes, our computers, our phones – everything got cheaper and the world looked to be functioning the right way for most of us!

When globalization went at a totally new speed with China dominating the world and the internet spreading to the remotest areas, it became clear that the world was facing a new challenge: deflation – when the price of goods falls over time instead of rising. The problem has started getting serious, especially as developed countries were not really growing much and on top of that, the interest rates have dropped almost to zero. I wrote about deflation last year; you might want to refer to that for more details.

Just imagine: would you lend money to others, if they were going to give less money back to you next year? That is what deflation is. The issue is that economies don’t function with deflation. Banks, insurance companies, pension funds, everything is based on one major assumption: that is there is inflation, and that interest rates are positive. In many of their business cases interest rates must be at least 2%. Imagine the government needs to pay pensioners a fixed amount every month, but the interest rate is getting lower and lower. It’s not possible to make meaningful returns – suddenly your promised payments are not sustainable. No doubt you can think of many other similar serious and important scenarios around us. That is why central banks try hard to manage inflation and deflation.

If we are not able to manage this deflation very well, the world can become a bit more difficult, and as we are seeing, nationalism takes over.  Nationalism is the opposite of globalization.  If globalization – along with the internet – drives deflation, nationalization and a censored internet leads to inflation.  Many countries’ prime agenda is to export the deflation, but I am afraid China can’t take that back. We are entering a very different world where many of our existing mechanisms suddenly don’t work.

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