Would Irving Fisher continue to defend the Net Present Value model in our era of sustainability?

Do you remember Irving Fisher? He may have been America’s first celebrity economist. A professor who taught at Yale, he doled out pearls of investment wisdom to the business press during the early years of the twentieth century.

But one interview, in particular, wreaked irreparable damage to his reputation. In 1929, at the height of his fame, Fisher attempted to reassure the jittery investment markets by declaring that equity values had reached “a permanently high plateau.” He implied that investors would be wise to hold onto their stocks and ride out any period of market volatility.

Those who followed his advice were in for a very long ride. The Dow Jones Industrial Average fell 89%, and didn’t recover until the 1950s. An entire generation of investors was wiped out, the nation plunged into a Great Depression, and Irving’s followers suffered a very harsh blow.

Nevertheless, Fisher did leave an impressive legacy. His classic 1907 book The Rate of Interest and 1930 text The Theory of Interest helped popularize the Net Present Value (NPV) model of Discounted Cash Flows. It remains the dominant valuation method of modern finance.

How does it work? In essence, it incorporates the Time Value of Money into an evaluation of an investment opportunity. Cash flows that occur in the near future are worth more today than cash flows that occur in the distant future. In essence, the burden of “waiting for one’s money” cheapens the latter type of cash flows.

Although Fisher didn’t invent this model, he did as much as any other individual to establish it as the cornerstone of modern valuation theory. And by doing so, he may have helped launch our society on an unsustainable path.

Why? Because, quite simply, it discounts the future. It ensures that we’ll always choose to receive a dollar today over a dollar tomorrow.

But what if we find a business opportunity that can yield billions of dollars of profits today? An opportunity, perhaps, that would trigger the impoverishment of our descendants one century in the future? Along with the utter degradation of our planet?

At any reasonable rate of interest, the impact of that future catastrophe would be discounted to zero by the NPV model. Indeed, any event that far in the future would be insignificant from an NPV perspective.

That’s the sustainability conundrum that faces our contemporary investment community. Although we may care about our distant future, our long-established investment methods fail to place any significant value on it. And yet, as the effects of climate change increasingly impact our environment, events that were initially expected to occur in the distant future are beginning to be felt in the present.

If Irving Fisher were alive today, would he still choose to defend the NPV model in our era of sustainability? Although he gave such wrong-headed advice to “stay the course” in 1929, we can only hope that he would offer more sensible advice to “change our course” today.

A Valuation Nightmare

Did you notice the news story that shook the foundations of our global economy last week? Although it didn’t receive much attention in the popular press, one doesn’t need to possess a PhD in Accounting or Finance to appreciate the potential threat that now confronts us.

You see, for the first time in the history of European finance, private corporations issued bonds with negative interest rates. Specifically, the corporations Sanofi and Henkel announced that they will charge investors to borrow money from them.

Although European government entities have issued securities with negative interest rates, never before have private corporations done so. Presumably, investors are now so nervous about the future of the European Union that they are willing to accept such terms from Sanofi and Henkel.

Why did this event shake the foundations of our economy? Because our global financial system is predicated on the assumption that it is worthwhile to invest for the future. Under normal circumstances, when a borrower pays interest to a lender, the interest payment represents an acknowledgment that the borrower is investing the principal in a project that is generating future value.

So what happens when interest rates turn negative? In essence, investors are incentivized to spend all of their money immediately, or to store their money in their proverbial mattresses, rather than investing in the private sector. And the calculation known as Net Present Value (NPV), which relies on positive interest rates to discount future payments to their current values, fails to function.

Furthermore, if we no can longer estimate the present value of future cash flows, many tangible and intangible assets will no longer possess calculable values. Commercial landlords, for instance, will no longer be able to estimate the values of their properties on the basis of their future rent receipts. And banks will no longer be able to estimate the values of their loans on the basis of their future repayments.

In other words, we’d experience a valuation nightmare. So why did the Sanofi and Henkel announcements garner so little public concern? Perhaps it’s because the financial press is assuming that their negative interest rates will prove to be isolated incidents.

If other private corporations start to issue debt at negative interest rates, though, there’s no question that we’ll start to hear about it. After all, if the practice of investing for the future is no longer perceived to be a generator of value, it’s difficult to envision how our economy will ever grow.

Sustainability And Net Present Value

How can an organization possibly know whether an investment in an economically, environmentally, or socially sustainable project is worthwhile? For instance, how can it place a value on a flex time policy that reduces rush hour traffic? Or on an energy policy that shifts from a carbon based fuel to a renewable source? Or on a charitable contribution that supports a local hospital?

That may have been the question that generated the most “buzz” among the attendees at last week’s First Annual Conference on Sustainability in the Big Apple. Co-sponsored by the New York Hedge Fund Roundtable and the New York State Society of CPAs, the Conference attracted financial professionals from around the world to ponder such weighty concerns.

It’s a very important consideration because, if organizations aren’t able to value such expenditures, they may easily decline to make them. And without such expenditures, we might find ourselves confronting numerous situations of economic decline, environmental crisis, and social unrest.

Many organizations are addressing this question by defining complex models and metrics for measurement purposes. The Global Reporting Initiative, for instance, has now issued its fourth generation (i.e. its G-4) of sustainability standards. And the Sustainability Accounting Standards Board is doing similar work for more than eighty industries throughout ten organizational sectors.

Sometimes, though, it can be helpful to rely on traditional approaches to solve contemporary problems. After all, even if such approaches cannot provide comprehensive solutions, they can offer the universal tools and techniques that we can utilize to address our challenges.

So, with this in mind, here is a question: can the simple Net Present Value method help us place values on sustainability expenditures? The NPV calculation was first formalized in Irving Fischer’s landmark 1907 text The Rate Of Interest. Although it is more than a century old, it still serves as the contemporary investment industry’s favorite valuation method.

Basically, NPV values an investment as the sum of the (discounted) future cash flows that can be attributed to it. Cash flows that occur later (i.e. in the relatively remote future) are discounted by a greater extent than cash flows that occur earlier (i.e. in the near future) in order to account for uncertainty and the ability of investors to accrue interest income over time.

So how would we apply this concept to investments in sustainability projects? Well, organizations that invest in flex time programs, renewable energy sources, and local hospitals would be helping people, societies, and organizations conserve and generate resources. The future value of such resources, discounted appropriately to the current year, would represent the Net Present Value of such expenditures.

Is there anything wrong with such an approach? Of course, reasonable people may raise all sorts of concerns about it. For instance, individuals with a deep sense of morality and religiosity may protest that this technique (perhaps disturbingly) expresses charitable impulses in purely financial terms.

But if we need to start somewhere, why not start with NPV, the most commonly utilized valuation metric of the past century of financial analysis? On the one hand, it may strike us as a somewhat simple option. But on the other hand, as Friar William of Ockham once taught us, it may be wise — as a general rule, or “razor” — to prefer simpler scientific constructs to more complex ones.