After offering the Dividend Toolkit at a rebate for the whole month of April, I’ve had many questions about stock valuation, most precisely about the discount rate. The discount rate is used to determine a stock value through the Discounted Cash Flow (DCF) model and the Dividend Discount Model (DDM). The problem is that depending on which number you use as the discount rate, the stock you are analyzing could look like the perfect underdog just because you didn’t put a high enough discount rate.
What is the Discount Rate?
In very simple words, the discount rate is the % of return you seek as an investor. For example, if you invest $100 today and you expect to earn $10 in 12 months from this investment, your discount rate is 10%. This is the return you earn as an investor to compensate for the risk you take when you invest money. The discount rate is usually represented by the risk free rate (how much return you would get if you would invest in Government bonds for example) + a risk premium. In other words; the discount rate is how much you should earn for your investment since you take additional risk.
If you do your own research, financial theory will lead you tons of calculations to assess the right discount rate. You will eventually arrive at the concept of capital asset pricing model (CAPM) and the weighted average cost of capital (WACC). Unfortunately, at the end of several hours of research, you will come to the following (and shocking) conclusion:
Stock valuation comes from art and not science
The problem is often that a small difference in the discount rate will lead to a huge difference in the “fair” stock price assessment.
How to use the Discount Rate if it’s not reliable?
This is where the “art” meets the “science”. Financial theory will help you find all kinds of magical calculations. But if it was that easy, I’m pretty sure you would only have to pay a few bucks per month to get access to a stock value calculation service. The thing is that all stock valuation methods are linked to the future ability of the company to generate either cash flow, earnings or dividend payments.
For beginner investors, it is important to understand that using a single stock valuation method will lead to losing money on the stock market. The discount rate will help you using both the DCF and the DDM. In order to feel comfortable with my valuation, I use more than one discount rate.
9%, 10%, 11, 12%?
The discount rate I use will vary between 9% and 12%. The 9% and the 10% are used for strong companies. A company with a strong balance sheet and an amazing dividend growth track record such as Johnson & Johnson (JNJ) will merit a 9% discount rate. I use a smaller discount rate as the investment represents a smaller risk. JNJ is a leader in a mature market and shows a strong and well diversified portfolio of products.
On the other hand, if I’m looking at a company showing erratic fundamentals over the past 5 years such as Garmin (GRMN), I will use a 12% discount rate to reward me for additional risk in this investment. GRMN is in the middle of a technological business shift as personal navigation devices face strong competition from smartphones applications.
Then again, it’s not an easy task to determine which discount rate to use. But using various percentages depending on the risk of a company will give you a better idea of the stock valuation. The best way to make sure you are using the right numbers is probably to try more than one stock valuation method and compare them. I personally use three methods combined together. You can read about it here.
How much time should be spent on Stock Valuation?
I’m not a big fan of stock valuation to be honest. The reason is simple; my assumptions are as good as yours. Therefore, if you look at JNJ and use an 11% discount rate, you will find the stock way too expensive compared to me. Who’s right at that point? Only the future will tell us.
I use the calculation spreadsheet found in the Dividend Toolkit and I use my stock valuation method in three steps. However, I don’t spend many hours determining whether or not it is the perfect time to buy a stock. Once I determine the company shows strong fundamentals, a great dividend growth perspective and it fits into my portfolio asset allocation, I simply hit the buy button.
What about you, what do you use for discount rate?
Disclaimer: I hold shares of JNJ but do not hold shares of GRMN
Image credit retrieved from Pinterest
Hi Mike. I’ve written a couple times about discounting future cash flow, and found little consensus in our community about the rates used. Until interest rates got so insanely low, I always used 3% above the 30 year US Treasury Bond yield. Now, I’ll go as low as 5% for a rock solid company…..but at that rate I want to see a double digit discount to the price I am paying. It’s a subjective thing, but it’s certainly worth paying attention to. Thanks for restarting the conversation.
-Bryan
Hello Bryan,
This is interesting; I’m curious; don’t you find most stocks undervalued using a 5% discount rate? I currently start at 9% for rock solid companies and I find most of them at fair value. Which kind of dividend growth rate do you use?
Mike,
Your quote “Stock valuation comes from art and not science” sums it all.
Even though I also use a Discounted Dividend Model (DDM), I’ve tweaked the parameters so the calculations make sense to me. For instance, I use a discount rate of only 3.5% (mainly inflation plus a risk premium) but I use lower dividend growth rates (to give me a margin of safety) and I stop the summation at 20 years.
In the end, stock valuation is really a mix of science and art. The DDM formula is like a canvas; it is the same for everybody. The art comes from knowing what to put in it!
Cheers!
This is why I also like to double and triple check my calculation with other ways to value the stock. Using both DDM and DCF and combine both model by looking at a 10 yr PE history helps in determining the “real” value of a stock. But in the end, the real value is only the one the stock trades at. No premium, no discount; only the stock price 😉
Cheers,
Mike.