140 ShowMetheMoney
counte dfor. Accounting earnings are affecte dby a host of account-
ing conventions, including, for example, the method of computing
the cost of goods sold, the method of depreciating fixed assets, and
policies concerning allowance for ba d debts.
But imperfect accounting rules are still effective. With respect
to earnings (as distinguished from, say, book value), accounting rules
work when properly and consistently applied. Even if depreciation
expense for fixe dassets such as computers is not a perfect gauge of
the future costs of replacing them when they wear out, for example,
it does capture a minimum reasonable amount that must be rein-
veste din the business to maintain its sales level an dcompetitive
position in the future.
Once a representative earnings figure is selected, the earnings
must be discounted. Doing this requires a suitable discount rate
(conventionally calle dthe capitalization rate or cap rate). It is the
rate of return require dto compensate for the risk of making the
investment, an dso it is equal to the risk-free rate (that available on
U.S. Treasury obligations) plus an additional amount to reflect the
particular risk of the business.
Assume you determine that GE’s expected earnings over the next
four will be about $4.10 per share. The price you are willing to pay
for the right to that $4.10 per share in the future is a function of
the rate of return necessary to compensate for the risk that the $4.10
per year will not materialize. It will equal the risk-free rate—say,
3%—plus a premium to induce you to take the risk of owning GE
stock.
A robust debate centers on what the right cap rates are for dif-
ferent businesses an dtypes of investments. In general, the lower the
risks involve din a particular type of business, the lower the cap rate.
For example, if there is a high degree of certainty that a business
will continue to perform as it has in the past, a cap rate in the range
of aroun d10% is appropriate. For businesses that present mo derate
degrees of risk, a cap rate in the range of 15 to 25% is better. For
particularly risky businesses, those where uncertainty about future
success is great, an appropriate cap rate coul drange from 30 to 40%
up to 100%.
Businesses whose earnings fluctuate widely in the ordinary
course may be seen as subject to a greater risk that estimate dearn-
ings will vary. For example, banks an dinsurance companies whose
assets consist largely of cash or investments are more expose dto
cycles of economic change an dmay warrant a discount rate in the