Do Low Inflation or Low Interest Rate Environments Justify Paying More For Stocks?
In this era of high valuations one of the standard justifications given for buying stocks has to do with the perception that investors should be willing to pay more for stocks during low inflation environments such as we have seen the past few years. When inflation is low the net present value of stocks is supposed to be higher when one invokes the dividend discount model. Briefly, this model states that the present value is equal to the inflation adjusted sum of all future cash flows discounted to present. This means that one should be willing to pay more for a stock in a low-inflation environment since present value will be eroded less relative to its value some years out, all other things being equal and assuming that nominal earnings are unaffected by changes in the inflation rate. And since the risk-free interest rate tends to be lower when inflation is low some will argue that one should be willing to pay more for stocks in order to achieve the same return in excess of the risk f
