Recently Nishith asked some questions on what discount rate to use in the valuation of stocks. Thought of sharing the original comment and the reply with you.
Dear Satyajeet – One question that I always wanted to ask value investors is that: “What discount rate one should use? Should it be the rate of return that you want from the particular stock? or The WACC of that particular company? or Something in line with 10 year G-Sec yield?. Your insight would be really helpful. Thanks.
Very good question. One that has kept leading researchers in finance busy for the last several decades. All three alternatives have followers.
The first option – your want – is formally called “utility function”. How do you react to the chances of gains & losses at different levels of wealth? Economists at the turn of the 20th century and now behavioural economists take this approach to discount rates.
The second option – risk free rate + risk premium – is formally called “no arbitrage pricing”. CAPM is a well-known variant (there are others). Prices of various financial assets are seamlessly inter-connected. The base is set by the price of risk free asset. Every other (i.e risky asset) is priced in reference to the risk free asset, plus the risky asset’s unique risk premium. Any other price leads to arbitrage opportunities and is unsustainable. Economists from the 1950s onwards took this approach to discount rates.
The third option – risk free rate only – is sometimes called the “Fed model”. It was observed that the long term returns in the US stock markets merely match those of US Treasury bonds. That is surprising, because the riskier stock market is supposed to give higher returns than the much safer bonds. Some say, Alan Greenspan was referring to the Fed model when he made that famous comment about “irrational exuberance” in 1996.
So then, which discount rate should you use? The first two alternatives have theoretical merits but are difficult to estimate with confidence in practice. The third alternative is easier to implement, but doesn’t have the required theoretical backing. It works only when you use it in conjunction with “certainty-equivalent cash flows” i.e. adjust for the risk in the cash flows instead of in the discount rates. It seems Warren Buffett, the patron saint of value investing, uses this method.
Consider a fourth option – reverse-engineering. Stephen Penman explains how to finesse the difficult estimation issues. You normally input a discount rate to get your DCF valuation as an output. Why not reverse-engineer the process? Take the current stock price, plug in the other inputs (i.e. cash flow projections) to derive the missing variable i.e. discount rate. You can compare the stock market’s discount rate thus found, with your required rate of return. Buy the stock if the discount rate is greater than your required rate of return. Sell the stock if the discount rate is less than your required rate of return.
Hope that answers your query, Nishith.