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Technology Stocks : Warren Buffett
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To: shean bond who wrote (24)12/25/1996 11:48:00 PM
From: Murti Gajjala   of 82
 
Shean,

I just happen to see this thread and the postings. Following is my explanation why capitalization is done by subtracting growth rate from the discount rate.

Final year earnings=E. If there is no growth, present value of future earnings, with discount rate of i (expressed as a fraction, e.g. .09)=

P1 = E(1+f+f**2+f**3+...) where f=1/(1+i)
= E/(1-f)
= E*(1+i)/i

If there is growth g (again expressing as a fraction, e.g. .05), present value will be

P2 = E(1+(fv)**1+(fv)**2+(fv)**3+...) where v=(1+g)
= E/(1-fv)

This is approximately equal to E*(1+(i-g))/(i-g) ...if you ignore 2nd order terms i*g + g*g relative to (1+i) which is like ignoring .007 compared to 1.09 which is reasonable.

This proves that the growth rate needs to be subtracted from the discount rate.

Murti
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