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.

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