Thread by @amitmantri

Seeing many DCF models in analyst reports where the WACC/COE has been reduced due to rate cuts leading to higher target prices.

But the same models don't reduce the EPS, ROE or terminal growth rate estimates. Why?

If rates are being cut due to lower inflation, will that also not result in lower nominal revenue and EPS growth?

Revenue growth is nothing but Volume x Price growth. Price growth is occasionally driven by pricing power but in most cases is just inflation. Lower inflation would mean lower revenue growth and hence lower EPS growth.

Lower COE should also lead to lower ROE if we assume the firm's competitive advantage is not growing. That implies a further negative impact on EPS. But models never assume a decline in ROE when COE is declining.

Terminal growth rates meanwhile have been fixed at 5% for all companies for over a decade in all financial models.

For eg. HDFC Bank has been able to grow EPS at ~20% over the last many years while generating an 18% ROE. However, most of it has been done in much higher inflation environments.

If inflation remains low for a long time, even HDFC Bank cannot sustain the 20% growth or maintain its 18% ROE. So if you are reducing HDFC Bank's COE in the DCF model, you should probably also reduce the projected growth and ROE metrics.

Unless of course if your reasoning is that HDFC Bank's competitive advantage has increased so much that it will be able to maintain past metrics even in a lower inflation scenario.

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