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Author: TMFGebinr Big gold star, 5000 posts Top Recommended Fools Old School Fool Supernova Phoenix 1
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Subject: Re: More thoughts on discount rates Date: 12/13/2010 4:29 PM
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Hi tj,

Thanks for your comments.

Yes, exactly, you pass over some good investments

Oh, certainly. But I'm not trying to find all the good investments. Honestly, nobody can. I'm trying to find enough that the market thinks very poorly of that actually are likely to do better than expected, and then ride the share price up as the market readjusts its expectations. If I manage to pick only winners (defined by rising stock prices after purchasing), nobody will be more surprised than me.


but what is worse is that this method will select the riskiest stocks. That can be very dangerous. Your screen will pick all the value traps and then you have to manually sift out the ones that are not "traps".

Yes, that is a concern. You always have to ask, "Why is this company disliked now?" And you can find yourself in the position of convincing yourself that it's "better than that, really!" That's where the due diligence comes in, asking questions about the accounting, the management, and the situation the company is operating in (e.g. Transocean). And that's also where my position sizing will play a role. For those that are most questionable, but still deemed good enough, a 2% position is all they get. For those that are pretty good, 4%. For those that I believe are great, 6%. So when I'm wrong, hopefully it won't cost too much.


I believe you have to account for the riskiness of the investment. You make good critique points about CAPM and beta. I think your "judgment beta" is better than completely ignoring relative risk.

Well, my standard 15% discount rate is already pretty pessimistic. However, if the company lives down to market expectations and only manages to produce free cash flow at the priced-in depressed level that puts it onto the watchlist in the first place (like the screened stocks do -- http://boards.fool.com/screen-results-28942797.aspx), then I'll expect to get an average of 15% return per year.

But there's another issue even when using a judgment beta applied to the cost of equity that I hadn't discussed yet. Here's the equation to remind us:

cost of equity = risk free rate + beta * equity risk premium

Right now, the risk free rate (commonly, the yield on 10-Year Treasurys) is pretty darn low.

Second, what equity risk premium (ERP) should we use? I've seen papers where it's been measured to be anywhere from 4% to 6% or so. Apply a 2.0 multiplier to that and that's a 4-point swing between the top and bottom of the range, which really affects the calculated intrinsic value. Why use 4% or 5% or 6%?

Not only that, but I seem to remember reading recently that the ERP has been declining for the past 20 years or more, based on what investors have been willing to accept. Why? And how does that historical view play out when we pick one that looks forward to use in our discount rate?

For instance, suppose we assign a 1.5 multiplier to an ERP of 4% and use a risk free rate of 3.3% (the current 10-Year Treasury rate). We get a cost of equity of 9.3%. If the company has any debt at all, the resulting WACC (which is supposed to be the discount rate) is almost certainly less than that because debt is usually cheaper than equity. And that's for a company that we've judged to be more risky than the alternative (that 1.5 multiplier).

OK, so then we "correct" it and say, no we should use a 6% ERP (resulting in a cost of equity of 12.3%). How is that decision to arbitrarily use a 6% ERP instead of a 4% ERP any different from just sticking a discount rate on the thing, as I do, and going on from there?

Here's another way to look at the same issue: If I want my portfolio to return 15% per year or more, which I do, what benefit do I get from using a discount rate less than 15% in determining what expectations are priced in for a given stock? Remember, discount rate and expected return are mathematically identical, just looked at in two different ways.

Another aspect of this issue is, if I use a 15% discount rate, does that mean I will automatically invest in the riskier companies, as your first comment implies? I don't think so. One, I'm not estimating growth (a source of error when generating the cash flows to be discounted) and then applying a discount rate to it (another possible source of error, compounding any errors from the first bit). I'm letting the market tell me what is expected for a given discount rate at a given price.

The question I need to answer, then, is just, "Is that growth rate reasonable, given what I know about the company?" In today's article on Microsoft, the answer I come to is, "Yes." http://www.fool.com/investing/value/2010/12/13/im-not-buying... And so, I decided not to invest.

Two, high discount rates have been traditionally applied to riskier companies, but there's nothing that says we can't use high discount rates to help determine an acceptable entry price for less risky stocks. Unusual maybe, but not against the rules (what rules?).

Three, I'm using behavioral investing to inform my decision. Is there disgust or ennui or despair surrounding this company? Look at the articles being written about it. Emotions like that tend to be shorter lived (though not always -- look at Microsoft over the past few years) and can often lead to mispricing.


Regardless, I'd love to read your or others' further thoughts on this issue. Maybe I'm doing something completely wrong.

Cheers,
Jim
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