Estimating discount rate is more of an art than a science. however, there are alternative approaches like the build up method where you start with risk free rate and layer up relative to the company fundamentals.
also you can use fundamental beta which replaces market volatility with fundamental risk like earnings volatility or operating leverages which ensures the discount rate reflects the business operations rathe than just stock price swings.
also, you can use alternative from real world proxies. For example VC hurdle rate for early stage should be your celling discount rate and you adjust downward from there .
but at the end cash flow is the king and getting lost in the weeds of decimal points will not do you any good. If your thesis relies entirely on 1% change in the discount rate then your margin of safety is very thin.
Excellent analysis, great back of napkin approach. Similar to your evaluation of capital requirements and how it impacts “g” I like to understand required reinvestment (where RR = (g/ROE)) and use that to adjust earnings (Adj E = E*(1-RR)) to compare different companies’ PE ratios. Clears out a lot of noise around capital intensity and more easily lets you compare PEs across industry.
I also prefer solving for Discount Rate:
https://www.moatmind.com/p/discounted-cash-flow-to-internal-rate-of-return
Estimating discount rate is more of an art than a science. however, there are alternative approaches like the build up method where you start with risk free rate and layer up relative to the company fundamentals.
also you can use fundamental beta which replaces market volatility with fundamental risk like earnings volatility or operating leverages which ensures the discount rate reflects the business operations rathe than just stock price swings.
also, you can use alternative from real world proxies. For example VC hurdle rate for early stage should be your celling discount rate and you adjust downward from there .
but at the end cash flow is the king and getting lost in the weeds of decimal points will not do you any good. If your thesis relies entirely on 1% change in the discount rate then your margin of safety is very thin.
Excellent analysis, great back of napkin approach. Similar to your evaluation of capital requirements and how it impacts “g” I like to understand required reinvestment (where RR = (g/ROE)) and use that to adjust earnings (Adj E = E*(1-RR)) to compare different companies’ PE ratios. Clears out a lot of noise around capital intensity and more easily lets you compare PEs across industry.
Hi Jon, sorry for the late reply. Yes, and you can also use the fundamental P/E ratio。
Can you explain more about the variables? Is g a compound growth rate in earnings?