In this week’s mailbag, I found a note from a former colleague working in the financial industry and studying for his CFA. He had read my recently re-published report on Chipotle Mexican Grill (CMG) and sent along a good question about selecting discount rates.
My answer speaks to the difference between “market risk” and “valuation risk” and is something I discuss in detail in our IOI 100-Series courses and Master Classes.
From Bryan M., financial services professional
Hi Erik!
I hope you are doing well. I re read your CMG article and the level of depth you included in that report was amazing! I’m actually doing a valuation myself for a project where we are asked to rate a stock. I selected CMG as one I’d like to evaluate. My question to you is with respect to calculating a discount rate.
I believe the CAPM Beta on YCharts (beta w/respect to S&P 500) is a poor way to estimate the companies discount rate. I believe the operational and fundamental characteristics of CMG vary significantly and the risk for the stock is not accurately reflected with CAPM Beta. Based on your IOI short term drivers, what would you suggest to do, to calculate a discount rate based on a companies fundamentals?
Best, Bryan
Erik’s Answer
Hi Bryan,
Thanks for your message — great to hear from you and I hope all is well. Looks like you’re working as hard as always.
My views on discount rate are not aligned with orthodox finance teachings. The essence of Efficient Market Hypothesis is that risk is represented through price fluctuation (because prices, in the EMH model, represent the value of the companies exactly).
Price fluctuations do certainly represent one sort of risk – market risk – but to me, a well-capitalized long-term investor who looks at stock purchase as an ownership stake in a business, it is not the most important one.
To me, the most important risk is one which I call valuation risk.
In my opinion, you can not choose a discount rate based on regression statistics that will successfully account for valuation risk. I give examples of this contention in our 100-Series training courses, in fact, and you’d be amazed at how easy this contention is to prove.
For selecting a discount rate, I suggest two things:
- Use a standard rate for all companies according to size. I use 10% for large cap and 12% for small cap because these are the long-range returns for each of those indices. The standard rate is saying “I want to make as much as the rest of the market. How much does the rest of the market make over time?”*
- Always remember that the choice of a discount rate is a sort of a “bet”. By choosing a certain discount rate, you may well be wrong, so it’s good to think about your choice of a discount rate from this perspective.
I’ll be publishing some research on Union Pacific soon that will illustrate that nicely, I believe.
Thanks again for the ping, Bryan!
All the best to you and yours,
Erik
* I had an email battle with an economics professor who told me that by not considering the risk-free rate, I was always using the wrong discount rate. He was doing the opposite – using the present risk-free rate and extrapolating out ad infinitum. Our conversation prompted me to investigate his contention and the topic of discounting each stage of a valuation using different rates more deeply. That research now forms part of our Master Class on Valuation.