tag:blogger.com,1999:blog-8152901575140311047.post6360829302967695030..comments2024-03-29T07:41:47.433-04:00Comments on Musings on Markets: Putting the D in the DCF: The Cost of CapitalAswath Damodaranhttp://www.blogger.com/profile/12021594649672906878noreply@blogger.comBlogger9125tag:blogger.com,1999:blog-8152901575140311047.post-77954903980433196222015-04-15T08:22:46.324-04:002015-04-15T08:22:46.324-04:00Hello Sir
Suppose I am using USD risk free rate t...Hello Sir<br /><br />Suppose I am using USD risk free rate to compute cost of equity for a business found in another country. The business cash flow is in USD instead of its local currency. Do I have to add inflation differential?Anonymousnoreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-17752914297463480942015-01-27T23:01:45.966-05:002015-01-27T23:01:45.966-05:00Professor, thanks for posting this great summary. ...Professor, thanks for posting this great summary. I have two questions:<br /><br />1) Because Equity is considered perpetual, or at least very long term, why not use 30-year T-bond to calculate Cost of Equity?<br /><br />2)I remember reading a paper of yours saying that we should use yield on zero coupon bond to estimate risk free rate to avoid reinvestment risk. Does the 10-year T-Bond rate in your article refer to zero coupon bond?<br /><br />Thanks!<br />Walker ZhouUnknownhttps://www.blogger.com/profile/12458220385333429312noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-16381383846999528672015-01-25T14:48:12.294-05:002015-01-25T14:48:12.294-05:00Ahmed,
The first thing to do is to let loose the n...Ahmed,<br />The first thing to do is to let loose the notion that the discount rate is the receptacle for all your fears and hopes. It is not. In my view, it is not the key part of DCF and rather than worry about the discount rate being too low or it being lightly correlated with future returns (it should in any diversified portfolio; that is a feature of diversification, not a bug), spend more of your time estimating the expected cash flows.Aswath Damodaranhttps://www.blogger.com/profile/12021594649672906878noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-3651430001423245832015-01-25T10:23:00.547-05:002015-01-25T10:23:00.547-05:00Thank you for the reply.
Then in your view, what ...Thank you for the reply.<br /><br />Then in your view, what is the best way of estimating Ke that investors should adopt? There are other multi-factor models besides the CAPM that attempt to 'explain' individual returns, but I think that for a well diversified investor (eg. institutional investor) the excess returns and losses that are uncorrelated to the market portfolio can be ignored, and are diversified away, leaving only the security market line as the single most practical way for the well-diversified investor in expecting future returns.<br /><br />But that leaves something to be desired, if the correlation of that specific security to the market is low, then the CAPM beta might not be a good indicator of future returns, which goes further to ascertain the use of other factor model in attempt to predict the E(R).<br /><br />With that said, how do you go about incorporating discount rates for equity, since the cost of equity should be unique depending on the marginal investor. Is it prudent to capture total risk, use multi-factor models as an inbetween solution, or use the more conservative CAPM?<br /><br />Interested to hear your insight!Anonymoushttps://www.blogger.com/profile/05778025701890012625noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-19233303803441291392015-01-25T08:36:00.649-05:002015-01-25T08:36:00.649-05:00Ahmed,
1. Who is we? I don't adjust my discoun...Ahmed,<br />1. Who is we? I don't adjust my discount rate for any of these and think it is a bad practice. It is sloppy, lazy and leads to the double counting of risk sometimes.<br />2. Yes and that is what I am doing. And if you do it right, it is also the marginal cost of debt.<br />3. See my answer to (1).Aswath Damodaranhttps://www.blogger.com/profile/12021594649672906878noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-31974268586995088552015-01-25T08:34:29.128-05:002015-01-25T08:34:29.128-05:00Prudent Investor,
1. I think you are mistaking wha...Prudent Investor,<br />1. I think you are mistaking what you want for what investors will settle for. I can almost guarantee you that there are investors out there who are pricing stocks to earn 5-6% and are perfectly okay with it.<br />2. Regional banks are actually far safer than money center banks. An old-fashioned bank that makes money off the spread and pays out 80% of its income as dividends is more bond than stock and should have a required return to reflect that.Aswath Damodaranhttps://www.blogger.com/profile/12021594649672906878noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-16309564546199882542015-01-24T16:32:06.356-05:002015-01-24T16:32:06.356-05:00Hi professor.
I have a few questions in valuation...Hi professor.<br /><br />I have a few questions in valuation.<br /><br />1) Why do we adjust the cost of equity for additional risk premias(liquidity, high growth, patent approval..) if we are using the CAPM? Isn't it valid to assume that all risk that is diversifiable can be ignored in deriving the cost of equity, since the marginal investor is assumed to be well diversified? If we include other factors in the model, shouldn't we also measure the beta of the same variables for all the other stocks to keep consistent?<br /><br />2) Shouldn't we use the current cost of debt for discounting cash flows, and then incrementally revert to the target (expected) marginal cost of debt on the long term? Or do we use the target from the start?<br /><br />3) How do we go about projecting future CFs so not to double count, or underestimate risk, that is captured in the cost of capital? You've mentioned before that adjusting the discount rate is a better method than reflecting risk in the expected cash flow (assuming the project/company goes as we hope to), or do we reduce the cash flows to reflect this added risk, and only plug in it's cost of debt, and the cost of equity based on it's industrial exposure to the market in the CAPM's beta? I find this part of valuation subjective and hard to measure. In fact, I don't really trust the CAPM in providing an accurate representation of Ke and expected return.<br /><br />For example, a turnaround commercial bank that is expected to grow substantially in the first ten years should not get the beta of the industry which is around 0.8, since that will likely overestimate it's value, then how do we adjust it's Ke in this case?<br /><br />Thanks a lot for all your work!Anonymoushttps://www.blogger.com/profile/05778025701890012625noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-31322412458040086592015-01-21T12:51:24.444-05:002015-01-21T12:51:24.444-05:00Professor, as always it is a great read. Thank for...Professor, as always it is a great read. Thank for that. Few short question:<br />1) Cost of equity for investor is a the required return, from practical point of view there is no point to invest in stock with required return say 5-6% when you have a risk free rate of 2%... it is hard to believe that the rational investor would choose it.<br />2) In your attached excel file -some cost of capital really look fishy-e.g.banks (regional) has 3.7% cost of capital and cost of equity of 5.2% vs. risk free rate of 2%...for valuation purpose this kind of cost of capital/equity will produce artificially high value, when banks assets is big black box (from risk point of view)-and diversification in this case also weak argument in valuation the specific stock, or?<br />What do you think?prudent investorshttps://www.blogger.com/profile/03470420269332654415noreply@blogger.comtag:blogger.com,1999:blog-8152901575140311047.post-68659412103794030812015-01-21T00:02:22.093-05:002015-01-21T00:02:22.093-05:00Prof. why is it that multi-factor models (FF3 or m...Prof. why is it that multi-factor models (FF3 or more) haven't caught on in Corporate finance to give a better estimate of different betas?Anonymousnoreply@blogger.com