Now that you're familiar with the concept of a discount rate, let's discuss how to calculate one. For now, we'll use simple examples to illustrate the concepts, then we'll teach you how to put it into practice in the next lesson.
One way to quantify a stock's discount rate is by using the capital asset pricing model (CAPM). The CAPM formula calculates an expected rate of return (E(Ri)) for an investment, which serves as the discount rate when using the DCF model.
The formula accounts for two main factors. The first is the market risk-free rate, which is the baseline rate an investor might expect to receive for investing in a risk-free investment. The second is the market risk premium, which is the additional return demanded for investing in stocks in general. The market risk premium is also adjusted for an individual stock's volatility.
For the risk-free rate (Rf), it's common for long-term investors to use the annualized yield on a 10-year Treasury note. Either way, the risk-free rate acts as a floor for the return demanded by investors willing to invest their money. It's the first term in the expression of the formula.
The second term in the formula is the market risk premium (Rm – Rf) adjusted for an individual stock's volatility. The market risk premium is calculated by subtracting the risk-free rate (Rf) from the market return (Rm), which is the average return of a market index like the S&P 500®.
Once the market risk premium is determined, it's multiplied by the stock's beta (βi), which measures the stock's volatility relative to the market. A benchmark index, such as the S&P 500, is used as a barometer for the overall market and has a beta of one. If the stock's beta is higher than one, this means the stock is more volatile than the market. This enhances the risk premium to account for the stock's volatility. If the stock's beta is lower than one, this means the stock is less volatile than the market, which reduces the risk premium.
Let's illustrate this with an example. Suppose an investor gathers the following hypothetical market information.
|
Annualized 10-year Treasury bond yield (Rf) |
2% |
|
Average S&P 500 annual return (Rm) |
8% |
|
Stock beta (Bi) |
1.5% |
CAPM formula
The result is a customized expected rate of return, or discount rate, that can help the investor determine the intrinsic value of that stock.
Don't worry too much about the mathematics at this point. You'll use the Intrinsic Value Calculator to estimate a stock's discount rate in the next lesson. For now, it's useful to know what's under the hood of the CAPM formula. Knowing what the key drivers are can help you more accurately account for risk in the DCF model.