I put little work in to trying to get correct the ERP, and hence a discount rate for any PV analysis to see if the market is over or under pricing a given stock; instead emphasis is upon the "story" of the stock and the underlying drivers of value: rev growth, margins, reinvestment rates, taxes. If those look unchanged or are increased or decreased based upon public information including management forecasts i would adjust views of my own sense of growth. A discount rate of whatever is not going to matter all that much as to the value if a guess as to the drivers of growth is a reasonable one. Stock prices are driven, particularly in the short run by the interaction of buying and selling of a stocks and a DCF will only give one a sense of the extent to which the market is being too conservative or aggressive regarding a stock with the role of the discount rate which includes an ERP component not all that important which is to say if one is to use a 4% vs a 6% ERP in their analysis it is not that meaningful vs having a reasonably correct sense of the drivers of growth.
Implied, current ERP is most probably higher than 4.23% for two reasons. Long term earnings growth expectations are higher than the assumed 4.18%, S&P 500 companies are expected to keep on outperforming the overall economy. And the risk free rate is lower than 10y TBond minus the default spread since the 10y bond also runs the risk of inflation in addition to the risk of default.
The ERP as a "fear and greed" index for the whole market — not just a discount rate input. What's your current implied ERP reading and how does it compare to historical averages at this stage of the cycle?
The point that using a fixed premium turns every company valuation into a joint bet on the market is the one I keep coming back to. It also explains a lot of the dispersion you see between a fair-value model and sell-side targets: often the two are not disagreeing about the business at all, only about the discount rate. The note that the small cap premium has not shown up since 1981 and is still routinely added is a good reminder of how long a bad input can survive.
Nicely done. WD Jackson, retired.
I put little work in to trying to get correct the ERP, and hence a discount rate for any PV analysis to see if the market is over or under pricing a given stock; instead emphasis is upon the "story" of the stock and the underlying drivers of value: rev growth, margins, reinvestment rates, taxes. If those look unchanged or are increased or decreased based upon public information including management forecasts i would adjust views of my own sense of growth. A discount rate of whatever is not going to matter all that much as to the value if a guess as to the drivers of growth is a reasonable one. Stock prices are driven, particularly in the short run by the interaction of buying and selling of a stocks and a DCF will only give one a sense of the extent to which the market is being too conservative or aggressive regarding a stock with the role of the discount rate which includes an ERP component not all that important which is to say if one is to use a 4% vs a 6% ERP in their analysis it is not that meaningful vs having a reasonably correct sense of the drivers of growth.
Very informative as always.
Implied, current ERP is most probably higher than 4.23% for two reasons. Long term earnings growth expectations are higher than the assumed 4.18%, S&P 500 companies are expected to keep on outperforming the overall economy. And the risk free rate is lower than 10y TBond minus the default spread since the 10y bond also runs the risk of inflation in addition to the risk of default.
Appreciate sharing, Prof.
Love any "-logue/logos" coming from you, Prof.
The ERP as a "fear and greed" index for the whole market — not just a discount rate input. What's your current implied ERP reading and how does it compare to historical averages at this stage of the cycle?
Historical ERP measures what investors survived.
Implied ERP measures what they demand now.
The real mistake is treating the price of risk as a constant while the transmission mechanism is changing underneath it.
The point that using a fixed premium turns every company valuation into a joint bet on the market is the one I keep coming back to. It also explains a lot of the dispersion you see between a fair-value model and sell-side targets: often the two are not disagreeing about the business at all, only about the discount rate. The note that the small cap premium has not shown up since 1981 and is still routinely added is a good reminder of how long a bad input can survive.