Guys as per aswath damaodran proff

Risk free rate= Growth rate for any company in perpeiuty stage

Can someone explain why

http://www.youtube.com/watch?v=kIKkZpCm8Aw&list=PLCx9J7CGoMIjDf1_ZDl9wxJRr7DqihQ17

plz see last 10 min in video

Guys as per aswath damaodran proff

Risk free rate= Growth rate for any company in perpeiuty stage

Can someone explain why

http://www.youtube.com/watch?v=kIKkZpCm8Aw&list=PLCx9J7CGoMIjDf1_ZDl9wxJRr7DqihQ17

plz see last 10 min in video

Same is also used in alternative investment Schweser book DDM valuation of public real estate investment

Does not make any sense. Risk-free rate is dependent on the investment horizon (e.g. t-bill vs. t-bonds) while the conjecture is that the growth rate is in perpetuity.

There’s nothing surprising. He’s assuming that the growth rate of the economy (GDP) converges to the risk free rate. In a way, this is in line with the Fed’s mandate (at least in the US). Of course, it’s a bit unrealistic for a lot of scenarios, but you can use this for valuing stable period TV for multiperiod models. You can also use this assumption for companies that are heavily tied to GDP movements… boring commercial banks or life insurance companies, for e.g.

whats the logic of his assumptions?

See this article: http://squashpractice.wordpress.com/2010/05/14/inflation-and-the-risk-free-interest-rate/

For the abstract, search for the topic, “Federal Funds Rate and Risk Free Market Rate.”

Unless you’re in the 1980s, the risk-free rate is a decent starting point for determining a stable growth rate.

This is a heavily opinionated statement my part, so take it at face value or do your own research - there’s a high probability that we’ll see interest rates in the US rise to above normal (what I deem around 5-6%) levels in the next few years. So I wouldn’t be surprised if we end up reliving the 1980s era high interest rates… as high as 10%, if not more. My main argument for this is that we have printed so much money in the US, that increasing interest rate is the only real way to pay off our debts. So if you have studied 1980s US economics, and you think interest rates will be higher than normal, then using the risk-free rate as a proxy for GDP growth may not be such a good idea. On average, though, over long periods of time, it is a decent assumption to use the risk-free rate as a proxy for GDP growth or vice versa.

So that is why our GDP growth is no anemic - fed should be raising interest rates rather than lowering them to promote growth…

Over a long enough time periodi, risk-free rate could be used for GDP growth estimates if there was risk-neutrality wherein there would be no equity risk premium:

From L2:

ERP = RM-RF (return concepts)

RM = GDP growth rate (Growth theories)

RM = RF (Damodaran above)

ERP = 0

Any takers?

Not sure how you arrived at this. How’s the market risk equal to the growth rate of the GDP.

Something I do (surprisingly) remember from L2 Econ is this:

P = GDP * (E/GDP) * (P/E)

In the long term, the price of the stock market is driven by the growth in the GDP factor.

Damodaran is not claiming that the stable growth rate equals the market risk rate. He is simply observing a trend to drive his analysis… for a long period now, the GDP has grown in tandem with the risk-free rate (range of 1-3%). That’s it.

The entire world would exclusively invest its money in the US if the US market risk rate were equal to (and as low as) the US GDP growth rate.

RM is market return in real terms - which you call the market risk rate (not commonly used term - but ok as long as you are consistent between nominal and real).

perhaps real growth is zero and he assumes inflation rate is long term growth rate. Makes some sense but not sure I would use this in any model to value a company.

Risk-free rate is dependent on time horizon, but the farther out the yield curve you go, the less the change in rate. Additionally, on average with a flat yield curve, the 10-yr and 30-yr rate will be approximately equal. Think about which risk-free rate is used to calculate cost of equity (a source of capital with an infitinite horizon). It is common to use the 10-year treasury bond. While the 30-year bond will give a better estimate of the risk-free rate for an infinite horizon, the 30-year bond is relatively illiquid and will not as accurately reflect market perceptions.

The rational for using the risk-free rate as the long-term growth rate of the economy for modeling is similar. While the estimate is of a perpetuity growth rate, the 10-year rate is probably a reasonable estimate. More importantly, the rate should match the risk-free rate used in the cost of equity. If the 30-year rate is used as an estimate of long-term growth rate, that rate will (currently) be higher than if the 10-year rate is used, increasing the valuation. However, if the same 30-year rate is used as the risk-free rate for cost of equity, WACC will be higher which will offset the increase in the assumed growth rate.

This also addresses the issue of differing risk-free rates in different economic environments. In the 1980’s, using the risk-free rate would result in a very high long-term growth rate. However, the same risk-free rate is used to calculate the cost of equity, increasing WACC and counteracting the high long-term growth rate. Also, embedded in this rate is expected inflation, so it is reasonable to assume that the company will also grow at this rate unless an explicit assumption is made that inflation decreases to a normalized level. However, if this assumption is made, WACC will also have to be adjusted, counteracting the assumption.