about The Market Discount Rate
The market discount rate is the expected long term rate of return for the overall stock market. An analyst performing a discounted cash flow analysis on a stock must estimate the market return as part of the process
Because DCFHub values thousands of stocks at one time, we do not need to estimate this number- we can actually calculate it through optimization. We'll get back to that in a minute.
Here is the formula relating the market discount rate to the discount rate appropriate for an individual equity:
ri − rf = βi(rM − rf)
Where
ri is the discount rate for the equity,
rf is the risk free rate of return,
βi is the beta of the equity in question,
and rM is the expected market rate of return, or the market discount rate
This formula, known as the capital asset pricing model (CAPM), was first proposed by William Sharpe in 1964. While there is some debate about the practice, the use of CAPM has become widely accepted and is very common.
When the risk free rate of return is assumed to be zero, the CAPM formula simplifies to:
ri = βi(rM)
DCFHub employs this simplified formula in our valuation computations.
Because the beta of an equity can be measured, and future earnings can be estimated using consensus growth rates, it is possible to solve for both the implied individual and market discount rates required to explain the current trading price of an equity. But calculating the discount rate based on a single equity can be misleading if the equity itself is overvalued or undervalued.
DCFHub employs optimization techniques to find the market discount rate that produces valuations best matching actual trading prices across the entire universe of stocks that can be valued. Because the resulting market discount rate is reflective of average market return expectations across every equity and every analyst, it is a reasonable estimate of the returns that you can expect if you buy stocks today and hold them for multiple years.
Because DCFHub values thousands of stocks at one time, we do not need to estimate this number- we can actually calculate it through optimization. We'll get back to that in a minute.
Here is the formula relating the market discount rate to the discount rate appropriate for an individual equity:
ri − rf = βi(rM − rf)
Where
ri is the discount rate for the equity,
rf is the risk free rate of return,
βi is the beta of the equity in question,
and rM is the expected market rate of return, or the market discount rate
This formula, known as the capital asset pricing model (CAPM), was first proposed by William Sharpe in 1964. While there is some debate about the practice, the use of CAPM has become widely accepted and is very common.
When the risk free rate of return is assumed to be zero, the CAPM formula simplifies to:
ri = βi(rM)
DCFHub employs this simplified formula in our valuation computations.
Because the beta of an equity can be measured, and future earnings can be estimated using consensus growth rates, it is possible to solve for both the implied individual and market discount rates required to explain the current trading price of an equity. But calculating the discount rate based on a single equity can be misleading if the equity itself is overvalued or undervalued.
DCFHub employs optimization techniques to find the market discount rate that produces valuations best matching actual trading prices across the entire universe of stocks that can be valued. Because the resulting market discount rate is reflective of average market return expectations across every equity and every analyst, it is a reasonable estimate of the returns that you can expect if you buy stocks today and hold them for multiple years.