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Strategies & Market Trends : Gorilla and King Portfolio Candidates
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To: John Stichnoth who wrote (3657)7/11/1999 11:15:00 AM
From: Mike Buckley  Read Replies (2) of 54805
 
Can't we assume that the risk-adjusted discount factor for dell should be something like 12%?

The main problem I have with a discounted earnings or cash flow analysis is that there are so many variables that one has to get right. Otherwise, the outcome of the analysis will not have any practical bearing on investment decisions. The discount factor is the variable that affects the outcome tremendously, as anyone who adjusts it even in small amounts realizes.

One prevalent idea is to use a discount rate that is equal to the required return on the investment. That makes the most sense to me and at the same time builds in an adjustment for risk. If we think stock ABC has an enormous amount of risk, we would require a comensurate amount of potential reward. Whatever that reward is (the required return to justify the risk), we would use it as the discount rate.

On the other hand, this method of evaluation would never, ever work for LindyBill. Using his required rate of return as the discount rate would keep him out of stocks entirely. As much as I joke about that, we shouldn't ignore the serious implication. The implication is that though a stock will ALWAYS appear tremendously overvalued using a 100% required return as the discount rate, my guess is that method would have kept all investors out of Microsoft, Intel and Cisco.

--Mike Buckley
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