In September of last year, I published an article to Framework Members entitled Discard CAPM – There Is a Better Way to Think About Cost of Equity. To make a long story short, my contention in this whitepaper is that the standard methodology for determining one of the most important inputs into corporate valuations — the discount rate or Cost of Equity — is fundamentally wrong.
ValueWalk published this article and several ValueWalk readers have made thoughtful comments on my thesis.
While the article is an old one, today, an institutional investor sent in an interesting question about that article, and I’ve decided to post the exchange here. Both the writer’s question and my answer contain some finance jargon (e.g., “levered and unlevered DCF”), so Framework Members are invited to ask about the meaning of these arcane terms during weekly Office Hours. Framework Members are also invited to discuss online on the Framework Forum post on this topic.
Both notes below are lightly edited for clarity.
Question from GB
Hi Erik,
Apologies for the blind email — I enjoyed reading your article / whitepaper on the invalidation of CAPM for purposes of deriving a discount rate. Although I certainly haven’t articulated it as eloquently, I have approached the assumed discount rate for a traditional unlevered Discounted Cash Flow (DCF) similarly. If I am leaning long, I typically default to 10% (at least as a starting point), influenced primarily by the approximate long-term return I would alternatively expect from owning an index.
Question for you: if you have any experience (or thoughts on) developing levered DCF models — projecting cash flows entirely available for common equity shareholders, net of all debt activity — how do you think about discount rate? Do you just leave it at 10%? Or do you adjust upward? I think the CFA and academic theory teaches the levered DCF discount rate should be higher, at the company’s cost of equity, relative to the unlevered DCF analysis, which contemplates discounting unlevered FCFs at the company’s Weighted Average Cost of Capital (WACC).
I’ve recently been working on a company that is a restructuring story and also has elevated leverage vs. peers. I developed a levered DCF as a check on my valuation, forecasting out all the debt service and making reasonable refinancing assumptions, and I’m wrestling a little bit internally with my current discount rate of 11% and whether it needs to be higher.
Any thoughts would be welcome. And thanks for the good ValueWalk piece.
Erik’s Reply
Hi GB,
Thanks for the mail and the kind words about the ValueWalk piece. Glad you liked it and found it thought-provoking.
I’ll frame my answer two ways… One way is when I’m doing a valuation for a corporate client. In this case, I follow the orthodox way – discounting Free Cash Flow to the Firm (FCFF) by the WACC and Free Cash Flow to Equity (FCFE) by the Cost of Equity.
When I’m looking at valuation for myself, like I mentioned in the piece, I don’t think that it makes sense to blend discount rates at all, so never do. I use 10% as a simple-minded hurdle for large caps and realize that over the short-term, sometimes I’ll be too demanding of my hurdle and sometimes too lax.
The bet that I’m making long-term is that there is something magical about the number 0.10, and honestly, I’ve been getting more and more worried about that assumption for reasons related to economic growth rates (which I think are fundamental to equity returns over long time horizons).
The hardest cases are those like you have described – a company that is highly levered. I do not believe that risk can be captured by any discount rate, so don’t think of “increasing discount rates for riskier companies” as is standard. Rather, I look at operating scenarios and try to assess how far a company would be from bankruptcy in worst-case operating environments (e.g., How well will cash flow cover interest payments? Are there any big principle payments that will need to be made or debt rolled?). In case a company’s profile is such that it really might be near the edge of a liquidity or solvency event in case of an operating environment downturn, I move its 10-K into the “Potential shorts in a downturn” pile and leave it at that.
The transition from a company owned by equity holders and to one owned by debt holders can be very sudden (e.g., Lehman Brothers, Bear Sterns), so if the 0-equity downside cases are at all plausible, I am not generally interested in holding that equity. There may be times when a company is in an operating slump and bankruptcy is possible, but for some reason, I think the upside scenarios are more likely; in these cases, I’ll allocate a small amount to that investment (or invest in Out-of-the-Money LEAPS if available) and just assume that I’ll never see that money again.
If there’s no risk of a bankruptcy, there’s no point in increasing or decreasing the discount rate, in my opinion. From a market risk perspective, one is more exposed (i.e., if the rest of the market is worried about a bankruptcy, the shares will be more volatile), but valuation risk should not be higher. Pitching an idea like this to a portfolio manager is hard, and there’s more career risk doing so. Position sizing is important in cases like this, because it’s nice to be able to take advantage of dips in price and not be destroyed or fired for them…
Anyway, that’s my highly unorthodox way of thinking about these issues. Fundamentally, I’m worried that discount rates never accurately reflect risk and especially that financial leverage has the potential to create discontinuous jumps in value in different operating conditions.
Thanks again for your mail. I hope you find my comments helpful.