In his latest article titled – Quit While You’re Ahead, John Hussman discusses what is the right discount rate. Here’s an excerpt from the article:
One of the most overlooked and misunderstood aspects of investing is this: the rate of return that you use to discount future cash flows to present value is also the rate of return that you can expect to earn over time if those expected cash flows are actually delivered.
Suppose a security will deliver a single $100 payment a decade from today. If you choose to discount that future cash flow to present value using a rate of 6% annually, you can quickly calculate that you’ll be willing to pay $100/(1.06)^10 = $55.84 today. The moment you pay that price, you can also calculate that your expected return is ($100/$55.84)^(1/10)-1 = 6% annually.
Did you need to “adjust” that expected return calculation for the level of interest rates? No, you did not. Given any set of future cash flows, the current, observed level of valuation is a sufficient statistic for the expected future return.
The fact that the discount rate is identical to the expected rate of return may seem obvious, but clearly it is not obvious to Wall Street. See, low interest rates may very well encourage investors to use a low discount rate to value stocks, and therefore to pay higher valuations.
But once high valuations are in place, the low future expected returns are also in place! In other words, low interest rates may encourage rich valuations, but they do not mitigate the poor subsequent market returns that result from those rich valuations.
You can read the entire article here:
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