This is the standard explanation many give to justify that equity markets, starting with the US, are currently far from overvalued. Then again, what do we know about the relationship between debt levels and the cost of equity (i.e. the equity risk premium)?
We know, from the Modigliani-Miller theorem, that a firm's capital structure has no impact on its valuation. Contrary to what many argue, the increase in a company's level of (low cost) debt vs. (high cost) equity - an increase in leverage - doesn't lead to a meaningful reduction in the average cost of capital. The reason is straightforward: an increase in leverage by increasing the company's insolvency risk leads to an increase in the company's cost of equity (the equity risk premium goes up). The increase in the cost of equity in turn fully offsets the lower cost of debt, resulting in an unchanged average cost of capital. As changes in the capital structure don't have any impact in a company's operating free cash-flow generation potential, it follows that a change in a firm's capital structure doesn't have any impact on its fair value. There is only one minor caveat: given that interest payments are tax deductible, an increase in leverage leads to a minor change in the average cost of capital via the debt tax shield (e.g. if (i) 50% of the firm's capital structure is made up of debt, (ii) the corporate tax rate is 25% and (iii) the average cost of debt is 4%, the average cost of capital is.......0.5% lower vs. a capital structure with zero debt and 100% equity. Only 0.5% lower!). But even then there is a limit to the benefits of leverage: at some point (dependent on the cyclicality of the underlying business) further increases in leverage lead to an increase in the risk of insolvency and cost of equity that starts to offset the tax shield advantage. Keeping adding debt once that point is reached starts to increase the average cost of capital instead of slightly reducing it.
By the way, that the capital structure has no meaningful impact on a firm's average cost of capital and valuation is one of the few things on which Warren Buffett, Charlie Munger and financial academics agree on. So we better take it seriously.
With this is mind, where does the world economic system stands now? This is how the world's debt levels have evolved since the year 2000 (courtesy of MGI - McKinsey Global Institute):
The world economy is today more leveraged than it was in 2007. This must surely mean that the aggregate risk of insolvency is today greater than it was back then. And knowing what happened in 2008, it is reasonable to conclude that the resulting increase in the cost of equity more than offset any tax shield advantage from the additional debt the system accumulated in the meantime. So, the risk-adjusted average cost of capital should be higher today than it was in 2007.
What does this mean to valuations in the world's leading equity market, the US? Assuming, very optimistically, that (i) today's average cost of capital is only 10%, (ii) the US economy will grow at 5% nominally per annum in perpetuity (2.5% real growth + 2.5% inflation) and (iii) companies' average dividend pay-out is 75%, US equities would be fairly valued at a P/E of 15x (with a pay-out of 65% the fair value P/E would be 13x).
The S&P 500 is currently trading at a cyclical-adjusted P/E of 29.9x, trailing P/E of 24.1x and 1-year forward looking P/E of 19.0x. If this is fairly valued, what is overvalued?
And remember: gravity does exist. In financial markets too. It's just that it is not Newton's gravitational principles that rule financial markets - it's Wile E. Coyote's: markets can deviate from fair value for a long time, but eventually the power of gravity takes over.
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