He does that, sometimes.
Ok, so two responses with still no actual counterpoint then (my points, BTW, are backed up by pretty much every peice of economic theory ever as well as current investment practice). Other than you know, trying to tell me I don’t have my degree and back pedaling on your initial statements that discount rates and time value of money are “bull chit” that don’t exist
TL;DR
Your point remains wrong, and a model of certain free cash flows for an equity still does not exist in theory or practice outside of a probability weighted model which is definitely not even near to certain. Additionally, the time value of money remains one of the core and most easily testible tenants of theory
Because you lost the argument at the beginning of this page, why should I waste my fingers typing any longer?
But if things were different, I would have addressed the following point(s), glad I don’t need to anymore, unless I willingly feel like addressing any of them.
Ok
I never said that. It’s not for risk free money.
force′ ma•jeure′
(mæˈʒɜr, mɑ-) n.
1. an overwhelming or irresistible force. 2. an event or effect that may be considered impossible to control or anticipate. [1880–85; < French: literally, superior force] On the contrary. The market loves pricing in risk. People lose money when they fail to.
Taken out of context like a champion.
Of course there isn’t, who would write a paper, and get it peer-reviewed because you don’t understand what ‘real’ means? If I have a dollar today, and that dollar gives me the same purchasing power 10 years from now, then they are equal. There’s your paper.
Which system are you referring to? How am I ignoring credit risk? What difference does a DDM or FCFM make? They both reach the same conclusions, do they not?
There is no right or wrong way to do it, I did it for illustrative purposes. It doesn’t make it wrong, nor right.
If I were an investor, I would count only the cash flows I could count on whole-heartedly. I’m not a statistics person, but something along the lines of a stress test if I needed to get intricate.
Highly doubtful.
*Shakes head*
*pause*
*face palm*
What a waste of currency.
This is exactly why you missed the point, when the answer is fairly obvious and extremely simple.
LOL, I like this Mr. Smart guy…
The gap between the RISK FREE rate and the rate of inflation reflects TVM. Thank you, I win.
Aaaaand you’re wrong. Because real world risk and opportunity exists between now and then, hence the gap between inflation and risk free return. Banks fail, nations fail, people die. If you get sick in 5 years and face medical bills, is that dollar you recieve in 10 worth the same as the dollar you could have received 5 prior and held on to? If someone has a good business idea you want to invest in, can you invest with that dollar in 10 years? No. Hence why a dollar today is worth more than a real dollar in 10 years.
so a bird in hand is worth 2 in da bush?
My point is, you have no way at arriving at “certain cash flows” without using a stochastic probability approximation, which factors in downside risk and replaces the role of the discount rate (but is mathematically equivalent) or you’re ignoring risk all together. There is no such thing as a certian CF on a non-dividend paying stock. Now you could add some form of stress test (read probability approximation mentioned above) or you could just haircut the number to some arbitrary threshold, but then you’d either be underpaying for the asset to the point that you’d never be able to invest by ignoring probable (but not certain) income.
No you don’t. And that ‘gap’ simply reflects inflation.
I like how you make up motion picture scenario’s in your head with your very own animated characters. Maybe someone else can write a wall of text to explain it instead.
There are many ways of arriving at any future cash flow, it doesn’t make it more or less right, until it does. That’s why cash flows are ‘projections’.
Using that logic, there is no way of arriving at expected cash flows, or deriving discount rates except using x, y and z. They are all most likely wrong, but roughly close to the point where you can invest your money with some degree of certainity. This shouldn’t be any different in that sense, but different in the work process.
“There is no such thing as a certain CF on a non-dividend paying stock”? Are you implying that a risk-free cash flow model for a dividend paying stock would give a higher valuation than a non-dividend paying stock? To take it a step closer, are you implying that a DDM for the same dividend paying stock would give a higher valuation than a FCFEM using a risk-free cash flow valuation? Then you understood nothing from what I’ve said. I suggest you go back through all the posts before making any more comments, as I’m wasting my fingers on off-topic discussions, when I clearly intended to avoid them.
^My point is you can’t tell me what a certain CF is on a non-dividend paying stock. IE, you have no idea to know what if any cash flows will actually be distributed to shareholders with any certainty. Maybe it goes 20 years and starts paying some big dividends, but maybe it goes bankrupt over litigation in 15. Maybe it matures in 10 and starts making payments. But my point is, there are no “certain” cash flows to shareholders from a non-dividend paying stock. Yes, you could use a FCF approximation, but now you’re no longer valuing certain cash flows to shareholders.
You prescribed using a risk free certain cash flow model and my point is that risk free certain cash flows don’t exist. Now you can go to stochastic approximations, but now it’s no longer a certain CF but rather a probability weighted approxmation of a certain CF, which by its nature will incorporate the the discount rate.
How is the gap between inflation rate and the risk free rate inflation? This is literally the definition of a symantically null sentence. You agreed that there is a gap between the rate of inflation and the risk free rate earlier. Now you’re saying the gap is inflation, which implies there’s no actual gap.
In otherwords, if I can realize a risk free rate of return greater than the rate of inflation, resulting in a gap which you have already admitted exists, then I could simply by real assets that have appreciated at a lower rate and have more of those assets. So my real $1 now buys $1.x where x>0 in future real assets. That is called real return and reflects the time value of money.
Again, I win.
If that’s true, then you can’t tell me what the expected cash flow is for a non-dividend paying stock either. Your name says Charterholder, yet I’m puzzled by your lack of L2 equity knowledge. I’ve already explained, in a risk-free cash flow model, how a dividend, and a non-dividend paying stock could be valued using two different methods, and both methods should give you the same outcome for each stock. The fact that you pull up dividends in this discussion clearly shows your lack of grasp on the topic at hand. It is entirely irrelevant.
As for the second half of that post, I won’t even bother to be honest.
Looks like my recommendation of going back to earlier posts fell on deaf ears.
I did not agree that there is a gap between the nominal risk free rate and inflation, but the real risk free rate. The real risk free rate is zero, remember? Oh wait, you haven’t read my previous post, of course you don’t.
You cannot buy risk free assets and expect a real return, because both do not exist.
Who said anythig about winning? And If it came down to it, then “You lose”.
Because the quote gets hard tdo read, my first statement was “the risk free rate is higher than the rate of inflation” and you said “ok”
I never said REAL anywhere in there. And I said RF rate is higher than inflation. Even if we assumed you misread and thought I said the REAL RF Rate, how is zero higher than inflation?
I love how you insert REAL into the conversation later and then try to accuse me of not reading through closely.
My point is that only dividends can be considered “certain CF to shareholders” using FCF is certain cash to the business. The FCF model uses expected reinvestment at the cost of equity with continuis compounding as an underlying assumption. Your discount free certain CF method does not, and therefore you need to know cash to shareholders, which is the point you keep missing.
Now you’re trolling.
No disrespect, but how are you a CFA charterholder?
Really? Here’s Damodaran on the subject:
http://aswathdamodaran.blogspot.com/2011/09/risk-free-rates-and-value-dealing-with.html
"Risk free rate = Expected inflation + Expected real growth"
Yes, but as I have been saying this entire time, he embeds the risk portion of the discount rate through probability weights to arrive at “certainty equivalent” and still uses a risk free discount rate (that is not inflation). He then defines that risk free rate in prior posts as “Risk free rate = Expected inflation + Expected real growth” as I defined above. Which demonstrates a non-zero real risk free rate aka time value of money. Which is literally what I’ve been saying the entire time. So in your first post regarding the method when you said, “see, no discount rate” you were literally wrong.
From the blog post you linked to:
"It is true that there are two ways in which you can adjust discounted cash flow value for risk. One is to estimate expected cash flows across all scenarios, essentially multiplying the probability of each scenario by the likelihood of that scenario unfolding, and then to discount those expected cash flows using a risk adjusted discount rate. The other is to take the expected cash flows and replace them with “certainty —equivalent” cash flows and discounting those certainty equivalent cash flows at the risk free rate."
He also adds this which reinforces my point about using this technique in real world scenarios, while the first bolded sentence below also reinforces my point that adjusting cash flows for certainty ends up embeddeing the discount rate which he demonstrates by equating the two (from the blog again):
"Bottom line. There are no short cuts in risk adjustment. It is no easier (and often more difficult) to adjust expected cash flows for risk than it is to adjust discount rates for risk (here he is pointing out that the probability weighting to arrive at certainty equivalent embeds the discount rate and is thus theoretically equivalent). If you do use one of the short cuts - counting only safe cash flows or just dividends - recognize when these approaches will fail you (as they inevitably will) and protect yourself against those consequences."
Thank You, Jesus God, can you just accept that I’m right now.
Ok, I’ve gone back and looked more carefully at what Mr. Smart is advocating. i think I get it better now.
A traditional DCF makes estimates of expected cash flows and then discounts them to the present by an inflation premium, time value (the RFR), and then a risk premium that combines systemic risk and presumably ones own risk of getting the CFs wrong for whatever reason.
tere is another approach that says that you adjust each individual CF for their risk to come up with a risk-neutral equivalent amount. Then you sum these up to get a valuation. Most of the time, you sum them up by discounting those at the RFR, which is generally taken to be a number that includes an inflation expectation and a time value.
So the point is that the adjustment for risk can be made directly in the cash flow estimate (e.g. You think $10 is due next year, but only $8 is certain enough to be considered a risk-free cash flow), or it can be made after you’ve estimated the cash flows in one single discount rate that you apply to everything. Given other conversations with Mr. smart, where he’s been searching for ways to break down the equity risk premium into a term structure that is more bond-like, this approach would seem to be more consistent with how he does things.
Sometimes this approach is called “Risk-neutral” because the cash flows that you are adding up have already been adjusted for their riskiness/uncertainty and need an extra adjective to distinguish them from the unadjusted expected cash flow, but it’s not the same as risk-neutral in the options world, because in the options world, the presence of a replicating portfolio means that you actually can match the cash flows without taking any risk. It also means that subjectivity enters the equation at ever single CF estimate. Is this better than lumping it into one single discount rate?? Only if you are able to be more precise about every cash flow’s individual risk than you are are about the whole stream.
During the summation process, it’s not clear to me what Mr. Smart’s aproach is to discounting. In at least one post, he says you make an inflation adjustment, but in others, he seems to say not to? I would think that inflation adjustments would be required in any sensible investment decision, but maybe it’s done at the same moment at you adjust for risk, and that’s where he does it.
As for time value, if you don’t have any time value, and a firm is assumed to be a going concern, then the valuation might well add up to infinity, especially if you aren’t making inflation adjustments somewhere.
Or perhaps what he’s saying is that as you go into the future, the portion of future cash flows that passes the “certainty” criterion gets progressively less. As long as that proportion gets less faster than the growth rate makes it bigger, then you won’t have a valuation of infinity, and basically amounts to a discounted cash flow, but with the mathematical actions being done in a different order.
My point here since the very beginning was that the discount rate is mathematically embedded in probability weighted “certainty equivalent cash flows” which Mr. Smart adamently denies while also denying the existance of a real risk free rate and denying the existance of time value of money. He denies that a real dollar now versus a real dollar in 20 years have any difference in value, in other words, the real risk free rate is zero and the risk free rate = inflation.