Traditional Discount rate or WACC (II)

Traditional Method: Discount rate or Weighted average cost of capital (WACC)

Most generally, the practice is to estimate the returns investors are insisting upon for companies bearing like qualities (in terms of industry, capital structure, maturation, size, competitive outlook, and so on).

• For companies with long records of sustained earnings, low rates are indicated, perhaps just a few points above the risk-free rate.
• For newer, more volatile operations, a larger premium is required.

The estimate requires exercising practical judgment based on learning what compensation is given to investors bearing comparable business and financial risks.

• What special business and financial risk do common stockholders face?
• What are the debt levels?
• What is the likelihood that debt investors would be paid before them or that high debt would throw the company into bankruptcy?
• What is the company’s financial strength and industry leadership?
• Is its market expanding or contracting?
• Is there room for growth that will add value?

In short, assessing risk relevant to the discount rate implicates the same questions value investors ask when defining circles of competence.

Value investors see risk as arising from either

• deterioration in an investment’s business value or
• overpaying for it in the first place.

Overpayment can result from inadequate or mistaken analysis of these questions. The possibility of misrelating price and value implies a commonsense point: High stock prices compared to earnings make for high-risk investments.

A value investor’s conception of risk differs from that of modern finance theory, today’s dominant model for defining risk. This theory measures risk using market price fluctuations as proxies for underlying business-value changes. While the exercise appears precisely scientific, in fact it is as judgment-laden as the traditional method. It also defies common sense: In this model, the fact that a stock price is high or low compared to earnings has no bearing on risk. Despite these weaknesses, the widespread use of this model warrants summarizing it as a contrast to value investing.

Also read:

1. Understanding Discount Rates
2. Risk-free rate
3. Traditional Method: Discount rate or WACC (I)
4. Traditional Method: Discount rate or WACC (II)
5. Modern Portfolio Theory
6. Portfolio Theory: Market Risk Premiums
7. Portfolio Theory: Beta
8. Is the market efficient, always?
9. Discount Rate Determinations: Summary