The combination of low discount rates and high projected growth is a particularly dangerous cocktail: as r and g converge, nearly 100% of the company’s value is based on far-off speculation 10+ years in the future. Valuations increase exponentially as r and g converge.įigure 2: Two–Percentage Point Decrease in Discount Rate Triples Price A two–percentage point decrease in the discount rate, however, from 5% to 3%, results in a tripling of the enterprise value to $102. Under these conditions, the present value of the firm is $34. #IMPLIED PERPETUITY GROWTH RATE OF CASHFLOWS FREE#Under the model, valuations are extremely sensitive to small changes in projected discount and growth rates.Ĭonsider, for instance, a company with free cash flow of $1 today, and assume a growth rate of 2% and a discount rate of 5% into perpetuity. The most popular application of this asset pricing model is the discounted cash flow (DCF) method, which hinges on two key factors: r (the discount rate) and g (a company’s long-term growth rate). This simple argument is theoretically very true in terms of the most basic valuation proposition used in asset pricing: the value of an asset is worth the sum of its discounted future cash flows in perpetuity. Source: FRED for interest rates, Ken French Library for price-to-cash-flow multiples on the extreme 95th percentile breakpoint of all stock valuations in the US market each June.
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