12-03-2015, 08:01 AM
Hi Hyperion and Tree, thanks for sharing your thoughts.
I buy quite "normal" stocks, so the beta cannot be -1 or 0. The beta for my stocks should be somewhere between 0 and 2.
That was why I decided to take an arbitrary value of 1. Is the CAPM still valid if I assume beta=1? Is it better if I try a range of values like for beta = 0.5 to 1.5?
The full formula I use for the discount rate is:
(Debt/Asset)*Rd + (Equity/Asset)*Re, where:
- Rd is the cost of debt (Can be calculated by taking interest expense/debt)
- Re = Rf + Beta (Rm-Rf)
If I use the "average 10 year E/P for the market index" as the discount rate, won't that mean that the cost of debt be ignored? (The Debt/Asset*Rd part)
How about if I use the average 10 year spread between the E/P for the market index and the risk-free rate as Rm-Rf? Would that be more accurate?
Sorry for the newbie questions.
Until now, I have only been using ratios like P/E and P/B in my analysis.
I am now trying to include DCF in my analysis, because I heard that it is a more objective valuation method (assuming that you get the inputs right!)
This is my first attempt, so I am have some doubts about the values I should use. Please let me know if I am not making sense.
I buy quite "normal" stocks, so the beta cannot be -1 or 0. The beta for my stocks should be somewhere between 0 and 2.
That was why I decided to take an arbitrary value of 1. Is the CAPM still valid if I assume beta=1? Is it better if I try a range of values like for beta = 0.5 to 1.5?
The full formula I use for the discount rate is:
(Debt/Asset)*Rd + (Equity/Asset)*Re, where:
- Rd is the cost of debt (Can be calculated by taking interest expense/debt)
- Re = Rf + Beta (Rm-Rf)
If I use the "average 10 year E/P for the market index" as the discount rate, won't that mean that the cost of debt be ignored? (The Debt/Asset*Rd part)
How about if I use the average 10 year spread between the E/P for the market index and the risk-free rate as Rm-Rf? Would that be more accurate?
Sorry for the newbie questions.
Until now, I have only been using ratios like P/E and P/B in my analysis.
I am now trying to include DCF in my analysis, because I heard that it is a more objective valuation method (assuming that you get the inputs right!)
This is my first attempt, so I am have some doubts about the values I should use. Please let me know if I am not making sense.
(11-03-2015, 05:24 PM)HyperionTree Wrote: [ -> ]Dear gzbkel,
Hyperion says:
There are 3 choices for Beta, namely 1, 0 and -1, each with different assumptions. Beta = 1 means you expect your stock price to be move in 100% same direction as the market index. Beta = 0 means your stock's price movement is independent of the market index. Beta = -1 means your stock's price movement is in the opposite direction as the market index 100% of the time. So when index up your stock down.
Choosing Beta = 1 means, if the market index PE is high, your discount rate is low. Thus when the market is overvalued, you tend to also overvalue your stocks. This is risky.
Tree suggests:
You might want to use peer group long term PE instead if you want to ignore the CAPM because volatility, as you say, is not risk.
For example, if you have 5 stocks in the same industry, you can construct an index based on these stocks. Then you may calculate the average 10 year E/P and use this to be your discount rate. Without a peer group, you can use the average 10 year E/P for the market index to avoid overvaluing your stock when the market is up. To be safe, test a range of discount rates to calculate your fair value.
There are times when you will be unable to ascertain the discount rate for a stock due to various reasons like market uncertainty or risk free rate policy uncertainty or exchange rate effects. In this case, it is better to look for another stock idea.
Cheers,
Hyperion and Tree