How To Cut Your Dependency on Mr. Market
Investors spend enormous amount of
time analysing companies, industries, trends and simply try to understand how
the business works. That is of course very much needed and at least basic
understanding is absolutely essential for correct asset valuation. However, in
the very end of the valuation process one deeply subjective variable may enter
into the calculation. And it may change everything.
The importance of the discount rate
is shown below. The table displays the upside/downside of an intrinsic value
relatively to price using different inputs as growth and discount rate.
Figure 1: Influence of Basic Inputs on Intrinsic Value
Discount
rate


Terminal growth rate

6,0%

7,0%

8,0%

9,0%

10,0%


2%

104%

52%

21%

1%

14%


1%

66%

32%

9%

7%

19%


0%

44%

18%

0%

13%

23%


1%

28%

9%

6%

17%

26%


2%

18%

1%

11%

21%

29%

Source:
Author’s Calculation
The question is, what should we use
as a discount rate? I would divide theories into two groups. First one
incorporates risk into the discount rate  CAPM, FamaFrench threefactor
model, Carhart fourfactor model, buildup approach. These models are widely
used. According to the study of Prof. Wagner at Zurich University, the multifactor models are able to
explain approximately 78% of the stock market returns^{[2]}. That
may be taken as a satisfactory high value. Capital asset pricing model, whereas,
explains only 63 % of returns and an unconditional dependency on CAPM may be
considered dangerous. Especially when valuing illiquid shares.
However, I would like to introduce
another approach, where the risk is not incorporated into the discount rate. The concept is based on opportunity cost.
Basic economic law, which has been also popularized by famous investor Warren
Buffett, is taught at Economics 101. The approach has its own shortcomings, but
it may provide an investor with another view on the markets. Useful especially
for those, who would like to cut their dependency on Mr. Market’s volatile
frame of minds.
Discount rate as a proxy for cost
of equity may be also interpreted as a required rate of return. What the
required rate of return should be? The opportunity cost. In other words, it should be expected return on the
investor’s second best investment. What is it for the majority of nonprofessional
investors? The return on a widely diversified index as MSCI World Index or alternatively
S&P 500.
The Expected Rate of Return on S&P 500
The expected rate of return on an
index may be paradoxically easier to predict than the rate of return on a
single investment. The total return on an index consists of two parts. One
reflecting the fundamentals and the other reflecting the behaviour of investors^{[3]}.
Let’s start with the easier part to
describe, even though not easier to understand or explain  emotional return.
The Emotional Return
The emotional return is the change
in P/E during the forecasted period. Price to Earnings ratio actually expresses
how much are investors willing to pay for each dollar of earnings. P/E is
materially correlated with investors’ emotions. If they become less risk averse
or the riskfree rates are very low, as they currently are, P/E is
skyrocketing.
The inverted value of P/E is so
called earnings yield. It falls as the P/E rises during times of lowinterest
rates.
Investors simply directly or indirectly
consider their opportunity costs. In other words, they compare all the
investments at hand and try to pick the one with the highest riskreturn
profile. If the P/E is low (earnings yield is high), the investment is more
appealing.
But what earnings yield is high
enough? The answer for the this question lies once again in the principle of
opportunity costs. The relationship may be shown i.e. using the S&P 500
Earnings Yield. As the FED rates fall, bond rates fall and consequently
earnings yields fall, since the investors shift their cash into more appealing
stocks. As the interest rates stay lower for longer, investors become less risk
averse. Money is cheap, its “wage” (interest rate) is low and hunt for yield
begins.
Figure 2: Fed Funds rate and yields relationship
Source:
FRED Economic Research, Shiller’s Data^{[5]}
Change in P/E isn’t only the
outcome of interest rates, but is also influenced heavily by investors fear or
greed. Emotions are unfortunately extremely hard to quantify and economists and
psychologists will have to come together to figure this out. Currently, the
most famous proponent of necessity of adding irrationality into investors
consideration is Nobel Prize Winner Robert Shiller. Shiller’s wife is a
clinical psychologist, which is I believe more than a coincidence.
The Fundamental Return
The fundamental return is
determined by adding earnings growth and dividend yield. It is the product of
real economic variables  productivity and growth^{[6]}.
In general, growth investors focus
on the earnings growth, income investors on the dividend yield and value
investors on the low P/E ratio. The superior investor should focus on all three
components.
To prove that the theory fits into
to the real world, I have calculated fundamental and emotional returns of
S&P 500. The sum of the two parts fairly well explains stock market total
returns over both long and short term periods.
Figure 3: Expected return model’s application on S&P 500
(values
as CAGR)

1990  2015

2005  2015

Earnings
Growth

6,2%

5,6%

Dividends

2,1%

2,1%

Fundamental
Return

8,3%

7,7%

Starting P/E

15,1

20,0

Ending P/E

20,0

20,0

Emotional
Return

1,1%

0,0%

Total
Return

9,4%

7,7%

Source:
Author’s Calculation
In addition, the longer the holding
period is, the more important the fundamental return is. Over the very longterm horizon, the effect of emotional return is
marginal. For example if the P/E contracted from 20 to 15 over the 30
years, it would make only 1 % a year CAGR^{[4]}. Over such a longterm
periods, dividend yield and earnings growth rate are much more important than
“market noise” displayed in P/E ratio. As the period becomes shorter, the
change in P/E starts to be more important. The variable is, nevertheless,
unpredictable over the few months or years horizons. Investment for such a
shortterm period is a pure speculation, which only disguises as investment.
Figure 4: Contribution of Fundamental and Emotional Return to the
Overall Market Return
Source:
Financial Physics
In order to calculate reasonable
expected return, investors should determine values of the three basic
components in the model. These components still have their own drivers. It
depends on an investor what granularity he chooses. The chart below shows the
basic principle, nevertheless, does not seek to depict all the meaningful variables.
Figure 4: Fundamental Return’s Drivers
Source:
Financial Physics
Expected rate of return on S&P
500 may be as shown in the table below. The calculation is based on a trend of
variables returning to their average (based on 2003  2015 period).
Figure 5: The Expected Return on S&P 500
next 10 years

Terminal


Real Sales
Growth

3,97%

3,97%

Change in
Net Margin

0,97%

0,00%

Inflation

1,00%

2,00%

Earnings
Growth

4,00%

5,97%

Dividend
Yield

2,00%

2,00%

Fundamental
Return

6,00%

7,97%

Starting
P/E

23,56

20,06

Ending P/E

20,06

20,06

Change in
P/E

1,58%

0,00%

Emotional
Return

1,58%

0,00%

Total
Return

4,42%

7,97%

Source:
Author’s Calculation
As a matter of course, different
investors have different beliefs and the exante rate of return will vary. The
concept, however, stays the same. The expected rate of return should be also
calculated for every year separately, since the expectations i.e. for inflation
will vary.
Opportunity Cost as a Basis for Discount Rates
The previously described theory
explains what drives the total return on S&P 500. How is it connected to
the discount rate? As was stated at the beginning, the required rate of return
should be the rate of return on the investor’s second best investment. If an
investor’s second best investment is a simple ETF on S&P 500, it’s expected
return may be taken as an approximation for his cost of equity.
That is still not the end of the
story. A sound investor has to create a margin of safety to take risk into
account. The concept greatly explained by Benjamin Graham is still important to
the present. Here, unfortunately, the art part of the investing comes.
Investors may calculate the intrinsic value of a company using the expected
rate of return on an S&P 500 as a discount rate and then apply MoS of
appropriate value. That should give them very specific idea of the investment
being undervalued, fairly valued or overvalued. The margin of safety vary, but
usually will be in 20 to 50 percent range.
It is of high importance to say
that the root of valuation must be an investor’s understanding of the business.
Without such a knowledge not only he won’t estimate the expected cashflows
correctly, but his approximation of the appropriate margin of safety will also
be of a poor quality.
Interesting fact is that CAPM is
not that much different from the previously explained theory. Its form is
widely known.
The beta of the whole index is by
definition equal to 1. Then, the cost of equity according to CAPM is also equal
to expected market return. The difference is obviously when calculating cost of
equity of individual companies, which do not have beta coefficient equal to
one.
Conclusion
Milton Friedman once said: “It
takes a model to beat a model.” That
holds true till these days. The assumptions of CAPM or multifactor models are
not 100 % reasonable, but the models are able to predict market returns fairly
well.
The goal of this article was to
introduce different way of approaching the discount rate without using beta and
being dependent on market volatility. Currently, analysts value the companies
and come up with target prices of various values. Although one of the
assumptions of the CAPM model is market efficiency. Target price should be then
always equal to the current price. Analyst’s position, who use the CAPM, is
therefore at the very least ambiguous.
Model using the opportunity cost is
by no means perfect. It shifts the
problem of riskcounting from the discount rate to the margin of safety, but
fails to quantify what its value should be. However, it may give investors
and analysts useful view on the markets and with enough experience also help
with coming up with an appropriate cost of equity (which is not dependent on
Mr. Market’s mood). Naturally, analysts may use both a standard model and the
introduced model to check how consistent the cost of equity is.
Author: Michal Šperka
Zdroje:
1) Do cen a
do melounů se nevidí. CFA Society Czech Republic Blog [online].
[cit.
20161121]. Dostupné z:
http://cfasocietycz.blogspot.cz/2016/09/docendomelounusenevidi.html
2) CAPM vs. Multifactor Models: Evidence from Switzerland. University
of Zurich [online]. [cit. 20161121]. Dostupné z:
https://www.merlin.uzh.ch/publication/show/11247
3) The Importance of Dividend Yields and Earnings Growth to Stock
Returns. Morningstar [online]. 2016 [cit. 20161121]. Dostupné
z: https://sg.morningstar.com/ap/news/MarketWatch/115502/TheImportanceofDividendYieldsandEarningsGrowthtoStockReturns.aspx
4) CAGR = Compounded Annual Growth Rate
5) Robert Shiller's Data [online]. 2016
[cit. 20161121]. Dostupné z: http://www.multpl.com/
6)
Financial Physics
Model. Financial Physics Model [online]. 2016 [cit. 20161121]. Dostupné z:
http://www.financialphysics.net/model.html
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