Discount factor at stock valuation or CAPM

The value of a company can be determined by summation of all future cash flows while discounting at a realistic rate.

When you invest your money in stocks today you have to apply a discount rate as a kind of compensation and safety buffer and this consequently influences the calculation of a company’s value. But what will be a fair interest rate you can call for when purchasing stocks of a company?

There are different possible approaches.

First for example you can use the price-earnings ratio (PER) partially for determining the discount rate by making use of the reciprocal of the price-earnings ratios. The shareholder receives his interest return in form of corporate profits .

For example a PE ratio of 20 corresponds to an interest rate of 1/20 = 5%.

However, the profits of companies are not constant. Counteracting rising or falling profits, you need to adjust the “fair” PER slightly up or down. But ultimately it all comes down to an abbreviated discounted cash flow method.

Determination of CAPM

The modern economics have developed a model to solve this question which is named the Capital Asset Pricing Model (CAPM). The basic idea of the model is the hypothesis that the risk of an investment in equities is represented by the fluctuation of the stock price. To handle a greater risk a higher interest rate must be applied in return.

But this model also contains handicaps inter alia on the assumption that the price fluctuation of a stock is a direct measure of the risk of the investment.
Value investing is more likely based on the assumption that while investing in stocks risks are derived from how the company is managed and from the company’s fundamental health and not purely and solely from fluctuations of the stock price traded at the market.

Relevant literature is concerned with the criticism of the CAPM .

The approach of PURE Rating

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