John, here is the link to the FAQ's for Evaluator. At the end of this post I have excerpted the section on how they calculate a discount rate. They start with a minimum of 15% and then make an upward adjustment for risk.
quicken.excite.com
The user can override their default discount rate by plugging in their own, and then hitting the radio button to have the model use the user supplied selection.
I think the 15% starting point for a discount rate is appropriate, given that average market returns have been in the 12-15% range over long periods.
I have begun using the model as follows:
1. I get the analysts average 5 year growth rate for the stock (from Zacks or wherever)
2. I plug in the symbol, and use the 5 year growth rate I looked up, then let the model calculate intrinsic value using its default discount rate.
3. Then I try different discount rates until I hit one where the model indicates the fair value of the stock is close to its current price.
4. The resulting discount rate that yields a fair value near today's stock price gives me a ROUGH idea of the returns I might expect from the stock.
As Mike Buckley pointed out, the models are no better than the inputs. If growth estimate is off, you're cooked. If base period earnings are not representative, you are forecasting from the dark. Also, the model just can't handle companies that are currently losing money.
It works best on companies that have stable business models and reasonably predictable earnings.
If you try the model on a YHOO or an AOL, I think you are getting "garbage in, garbage out". I think the model is very appropriate for a DELL, MSFT, or CSCO.
On a QCOM, I would proceed with caution, since base period earnings are very much in transition, with some business lines being sold. What base net income number would be appropriate to use for QCOM?
Growth rate?
I would love to see some analysis on these numbers from the QCOM experts on the board.
Sorry for the long post.
Brian
The discount rate excerpt:
Q: How do I determine an appropriate discount rate for the intrinsic value calculation?
A: The discount rate is designed to take into account the gain you'd need to realize to make your investment in a given stock worth the associated risk ("opportunity costs"). The discount rate factors in:
• The bond rate: Your investment could grow risk-free at the bond rate. You'll need to beat this rate to make your investment worthwhile. Matching the bond rate also means automatically that your money will grow at or above the rate of inflation; if you fail to keep up with inflation, the purchasing power of your investment will dwindle over time.
• A "risk premium": You're probably looking to realize a certain percentage gain over and above the inflation and bond rates to make assuming the investment risk worth your while. The size of this risk premium is up to you.
Add the bond rate and risk premium together to arrive at a discount rate suitable to your investment expectations. Enter the discount rate into the text box. If you wish, you can leave the discount rate set to the default.
To calculate the default discount rate, Stock Evaluator uses a basic discount rate of 15% (assuming a 6% bond rate and 9% risk premium). Assuming that younger companies pose a greater risk than older, more established companies, Stock Evaluator adjusts the default discount rate according to the age of the company (determined by the number of years of financial reports available) to allow for the attendant risk, as follows:
• For 9 or more years, no risk adjustment
• For 7 to 8 years, add 1%
• For 5 to 6 years, add 2%
• For 4 years, add 3%
• For 3 years, add 4%
• For 2 years, add 5%
• For 1 year or less, add 6%
So, for instance, the default discount rate for a 3-year-old company is 19% (the 15% basic rate plus a 4% risk adjustment).
You may also choose to set the discount rate to mirror a stable rate of return by selecting from the pull-down menu, which includes the rates for a 1-year T-bill or 30-year long bond, among others. If you use a discount rate from the pull-down menu, be sure to click the radio button next to the pull-down to indicate that you'd like that value used in the calculation. Then click "Recalc" to see the new result. |
