142 ShowMetheMoney
woul dgive us a value per GE share of $100 (5.00/.05). If you go
further an d deem a lower cap rate of, say, 4% more appropriate given
GE’s prowess an dcurrent business opportunities an dcon ditions, the
value per share shoots up to $125 (5.00/.04).
This play with the numbers gives a valuation for GE with a fairly
wide range of $82 to $125. The range is broader yet if we take a
more pessimistic view. If you use only the average earnings of the
past four years of $2.66 an dstick with our original discount rate of
5%, the valuation is about $53. If you believe the roa dahea dis
riskier than the roa djust travele dso that a cap rate of, say, 6% is
more suitable, the value becomes $44 per share, generating a “Texas
range” from $44 to $125.
The selection of your earnings estimate an d discount rate is cru-
cial to this exercise. (A plausible range of values for Amazon.com,
for example, starts from zero and goes to a few hundred dollars!)
But even if you make those selections ruthlessly, your result cannot
be the “answer” to the question of what a share of such stock is
“worth.” After all, there are plenty of steps in the process where your
judgment could turn out to be wrong.
SILVER BULLETS AND THE MARGIN OF SAFETY
Most people agree that discount rates are driven by the risk-free rate
of interest in effect from time to time, usually that available on U.S.
government bonds that are deemed free of any default risk. This
coul drange from the prevailing rate of about 3%, to the historical
average of about 3.5%, to the present rate on inflation-protected
government bonds of about 4%. Some people use bonds of shorter
durations (such as 30 days instead of 30 years), but since equities
are inherently long term (i.e., corporations have perpetual duration),
it is probably better to use the long bond.
After settling on a risk-free rate, you then add a premium for
your stock. The tendency is to look at the average rates of return on
equities overall for long periods of time, which has been roughly 7%.
That gives you an average risk premium of 3 to 3.5%, which must
be tailored to the individual stock you are investigating. The rules
of thumb mentione dabove get you a long way here, though you
shoul dknow that many try to be very precise about these matters.