Discount rates are an elegant way to whittle a three dimensional concept down to one dimension. But they are inexact. For starters, a brief definition of a discount rate:
A discount rate is a percentage amount by which you reduce future cash flows to calculate what they would be worth today.
The interest rate used in discounted cash flow analysis to determine the present value of future cash flows. The discount rate takes into account the time value of money and the risk or uncertainty of the anticipated future cash flows.
Pretty good definition.
Ok. So which would you rather have - one dollar today, or one dollar and ten cents next year? Discount rates attempt to tackle that problem. In terms of an investment, your cash and assets today is the "first dimension."
There are two risks that discount rates account for. 1. The risk that you will not be paid tomorrow (uncertainty/variance of cash flows, the "second dimension") and 2. The risk that inflation will make money tomorrow worth less than it is today (risk of time and inflation, the "third dimension").
Let's say you have one dollar today, and you can invest that in a loan that 95% of the time will pay you $1.10 next year and 5% of the time will pay you $0 next year. A discount rate takes the $1.10 and reduces it by the risk of default. The higher the probability that you are paid $0, the higher the discount rate. If you determine your discount rate is 10%, then it is a theoretically neutral present value project, with a $1 net present value and a $1 price. An investor should be ambivalent.
The trouble is that the probability trees of payments on investments are not shaped the same. Some investments are all-or-nothing, like the one above. Some are closer to normal probability curves. Some are oddly shaped. For example, the future cash flows of USEC, Inc. (USU) are dependent on whether it receives a loan guarantee from the U.S. Department of Energy. Any future income projections for five years from now will be skewed away from the average because the loan will have such a big impact on the results of the company. But that investment might have the same discount rate as another with a set of returns that are highly volatile and centered around a mean. To investors, the differences between these returns are meaningful. Investors have different capital needs, so they care whether their returns are more centered or skewed toward 0. So that's the first way discount rates can fail: they take different arrays of returns in a fixed period of time and try to put a single price on them. Taking two dimensions of income down to one number.
The third dimension of cash flows is the timing. Discount rates put a single price on differently timed cash flows. So if you have one investment of $1 that pays $1.10 next year, and another one that pays $1.46 in four years, a discount rate might find these two investments of equal value. But to an investor, there is a big difference. Some people need money earlier, and some people can wait and are more long-term investors.
Discount rates are also difficult to calculate. Wall Street uses a CAPM formula, but I believe that formula is incorrect. Bold statement, I know. But a lot of successful investors agree with it. For example, Warren Buffett:
The riskiness of an investment is not measured by beta (a Wall Street term encompassing volatility and often used in measuring risk) but rather by the probability -- the reasoned probability -- of that investment causing its owner a loss of purchasing power over his contemplated holding period.
The most accurate way to analyze an investment is to project the actual cash flows into the future without discounting them. Note the shape of the probability curve and the timing of the cash flows. If you foresee everything being normalized, with nothing skewed in terms of the probability curve or the timing of returns, then apply a discount rate based on the chance that inflation will reduce your spending power and the chance of variation in the future returns. Some quick examples: A discount rate low-risk, constant payment, such as an annuity from a company with good credit, might be in the 5-8% range. A stream of steady cash flows from a company with a good balance sheet and a low risk of default (for example, Google (NASDAQ:GOOG)) could be discounted in the 10% range. A company with steady stream of revenues but a higher debt burden (for example, Goodyear (NYSE:GT)) might have a slightly higher discount rate, in the 15-18% range. A company with intermittent income and uncertain cash flows should not be subject to discounted cash flow analysis.
An investor can take advantage of the market's intermittent misuse of discount rates by screening for high-beta stocks with low price to book value. By doing this, you will find companies whose future earnings are under pressure according to the market. Then supplement your own research to find the hidden gems, which you believe will make money in the future and are trading at a discount right now. Here are a few stocks that might fit these metrics:
|Bank of America (NYSE:BAC)||2.65||0.39|
|CBS Corporation (NYSE:CBS)||2.31||1.96|
|Dow Chemical Company (NYSE:DOW)||3.03||2.27|
|Gannett Company (NYSE:GCI)||2.75||1.44|
|New York Times Company (NYSE:NYT)||1.72||1.82|
|Research in Motion (RIMM)||2.17||0.76|
Again, this is not the be-all, end-all for stock valuation. But it could be a good place to start your analysis.