Choosing a Discount Rate for Dividend Discount Valuation
Summary
The document asks whether a policy interest rate can serve as the discount rate in a dividend discount model. The response distinguishes using a rate to discount aggregate cash flows in a macroeconomic asset-pricing study from valuing an individual company’s equity. For a stock valuation, it argues that the discount rate should reflect both a risk-free component and compensation for equity risk, rather than treating dividends as risk-free cash flows.
It describes a basic approach that estimates the equity risk premium using CAPM: multiply the stock’s beta by the market’s excess return over the risk-free rate, then add that premium to the risk-free rate. The answer gives no calculation or empirical comparison and presents CAPM as a simplified example, noting that risk-premium estimation has other approaches and can vary materially. The central caveat is that a policy rate alone is not generally an adequate equity discount rate.
Key ideas
- A policy rate used to discount broad cash flows in a research paper does not automatically suit single-stock valuation.
- A dividend discount rate should include compensation for equity risk as well as a risk-free component.
- A basic CAPM estimate multiplies stock beta by the market excess return.
- CAPM is a simplified risk-premium method, and estimates can vary across stocks and approaches.
Tags
Full text
# Using interest rate as a discount factor in dividend discount model # Using interest rate as a discount factor in dividend discount model In this paper, Galí and Gambetti calculate the fundamental value of asset price by using policy interest rate as a discount factor. I was wondering if the policy rate can be used in this kind of fashion in a dividend discount pricing model. ## Answer by Fr1 (score 1) https://quant.stackexchange.com/a/41534 From a quick look at the paper, I see that the main purpose of the paper is not single-stock valuation. If you are an analyst at an investment bank (for example) and you use as a discount rate for dividends a risk-free rate without attaching a risk premium, then you likely get fired immediately, as that would assume that a stock investment is risk free and deserves a risk free rate for discounting, which is terribly false. So, simplifying a little bit, you shall use a discount rate r which is built as the sum of two components: - one is the risk free rate which is usually proxied by the YTM paid annually by same-currency long-term bond like 10y or 20y provided that the selected maturity is liquid enough and there exists a proxy for a risk free in that currency (otherwise you have to draw a return from another currency, like the us 10y and convert it through PP Parity) - one is the equity risk premium. In its simplest form the equity risk premium is estimated through CAPM model equation, so ERP= stock_beta *(market_index_return - risk_free), where (market_index_return - risk_free) is the historical average of market excess returns and stock_beta is the market beta of the stock estimated over the same period. Be careful that this is not the only way to estimate the risk premium, whole books are dedicated to it. It is just the simplest one. The risk premium estimate may vary a lot from stock to stock but, just to give you an idea of why it would be wrong to avoid counting it, the equity risk premium can add 10% to the risk-free resulting in a absolutely lower valuation, because this component of the model is what allows you to take into account the specific risk of the business of the company through its beta. In the paper, it was likely that they only needed a discount rate to discount cash flows. Their intention was not to build a DDM.
Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)
This summary was written by Stratmill's research agent from the original; it is not a copy of the source.