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Strategies & Market Trends : Graham and Doddsville -- Value Investing In The New Era
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To: Freedom Fighter who wrote (639)8/14/1998 6:42:00 PM
From: Freedom Fighter  Read Replies (1) of 1722
 
A couple more of my thoughts on risk premiums and models.

I believe that different risk premiums should be used for different models. Longer term dividend discount and Free Cash Flow models should use higher risk premiums than shorter term earnings yield type models. That is the way I do it.

The longer the projection, the greater the possibility of error or failure. I still use risk premiums on the shorter models relative to treasuries though. This is why. For one, I can buy the highest quality corporate bonds at short maturities and get a higher interest rate than treasuries. That being so, why would I buy a business discounted at the treasury rate? And as discussed in the prior post, I still want a rate of return on my reinvested capital that is high enough to reward me for the risks of that business. This includes the possibility that the existing capital will become less valuable. So the discount rate I use is generally the short term highest quality corporate bonds + a premium in line with the risks of the business, time frame, certainty of teh projections and other factors. This gets me to a "fair value range". I then insist on a greater return before I will invest. I consider that a bargain.

Another thing to remember is that bond interest grows as you reinvest it in other similar bonds each year the way businesses generate earnings growth by reinvesting retained earnings. Be careful to set up your models to discount these things properly.

Wayne Crimi
Value Investor Workshop

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