Valuation premium of listed companies is mainly divided into growth premium and certainty premium. The former is easier to understand: after the growth premium is reflected in performance growth, the forward valuation of the company will drop. For example, before 2015, investors placed high growth premiums on fast-growth or high-potential companies listed on the A-share market, mostly small-cap ones. The premiums, however, were too high even after years of future performance growth, eventually leading to persistently sluggish trading in small-cap stocks. After 2015, as the base of institutional investors expanded, blue-chip A-share growth stocks with a higher certainty of long-term performance growth have been valued with premiums. Valuations of leading companies in the consumer, pharmaceutical, and technological industries have risen from far below the average of the mature market to far above. Where the market is heading and under what conditions remains debatable. The key is to understand how the market value premium of certainty.

Valuation is the result of market trading, and appears to be influenced by the investment preference of the market. It is unpredictable and has to be described as an art. However, if we look at valuation not as a short-term speculator that aims at making money from counterparties, but rather as a long-term institutional investor, then buying the shares of a listed company is a way to share the benefits of its future growth and would mean an extremely low turnover rate. As a result, the listed company can be valued by the classical model of discounted cash flow.

Where FCF₁ is the stable cash flow in the company’s early stage, R₀ is the risk-free rate (usually the yield of long-term government bond), R_m is the risk premium rate expected by investor, and g is the future perpetual growth rate of the company’s free cash flow.

This equation tells us that a company’s value hinges on a continuous free cash flow in the future. To predict the future performance trend of a company, institutional investors hire a large number of industry researchers who analyze in depth the company’s fundamentals, including core business competence, business model sustainability, and financial quality. Generally, companies that will own a continuous free cash flow in the future are industry leaders that survive fierce market competition and possess core competitive advantages.

The denominator of the model involves three rates. First, the risk-free rate has fallen notably in this era as developed economies like the Europe, the U.S., and Japan adopt zero interest rate, and the yields of long-term government bonds have lingered around 2.5% and 1%, respectively at home and abroad. Second, the risk premium rate expected by investors is mainly determined by their opportunity costs, and is directly correlated with the risk-free rate on the whole. Given the current ample liquidity, a risk premium rate of 5% is estimated to be universally acceptable to investors. Third, the long-term perpetual growth rate of a company’s free cash flow, or g, is theoretically assumed to be 0, meaning a company will always end up with a decline. Yet our decades of experience in studying the business operation of both foreign and Chinese companies shows that g can be larger than 0 for highly-certain companies that boast robust governance structure, strong core competence, relatively stable business model, and high financial quality. For example, a leading liquor producer in China, though its sales in the long run stay flat, can still be reasonably expected to grow at 5% per annum under the inflation effect.

Simply assuming that the net profit of a company in the coming period equals its free cash flow, we can see the valuation indicator, or forward PE = 1/(R0+Rm-g). For one thing, as developed economies enter the long cycle of zero interest rate, sustained ample liquidity will bring down the risk-free rate R0. For the other, the future perpetual growth rate g of leading companies with high business certainty is expected to grow. The resulting significant decrease of the denominator will generate a valuation premium of certainty, hence much higher corporate value. In extreme cases, if the market expects the perpetual growth rate of a company is higher than the sum of the risk-free rate and the risk premium rate, the value of the company can be infinitely high in theory. This may explain the sky-rocketing valuation of leading ophthalmologist clinics and soybean sauce producers on the domestic market and leading cloud computing companies and self-driving auto manufacturers on the overseas markets.

Looking into the future, we can predict the stock price of a company with high business certainty will take a downturn, only when a fundamental change in its business competence undermines the continuous growth of its free cash flow, or when the risk-free rate is expected to trend up. Before then, the high valuation premium of the company will hardly fall, despite its occasional underperformance.