Let me make a quick note about the systematic and perpetual misuse of discount rates by many in the financial field, including many so-called "experts".
Often you will see analysts discounting a company's equity earnings at 10-12%, but their bonds are discounted at 4-5%. The reason given for this discrepancy is that debt has a lower "cost of capital" than equity.
Well, that's not always true.
Cost of capital is synonymous with the discount rate used to find the present value of future cash flows. Every set of future cash flows should have a unique discount rate based on the risks of those cash flows. There are two risks that must be considered in every discount rate: 1) The risk that inflation will make the real value of money decrease by the time you are paid; and 2) The risk that you will not be paid as promised. These risks should be evaluated the same way whether your payments come from debt or equity. (The structures and order of payment of debt and equity is, of course, different because debtholders get paid before equityholders. But as you will see below this difference is misunderstood in a lot of cases.) Most people do not understand the difference between debt and equity financing, and place an artificial premium on equity that should not exist.
Here is an example: Company A has existed for 100 years. It makes mirrors. It sells to a variety of retailers with long-term contracts in place to supply mirrors for the 5 years, that are automatically renewed every 5 years. The prices are set based on inflation, and Company A's profit margin is relatively constant, but varies slightly with market ups and downs. Its Beta is 1.0. In 2013 Company A will make $100,000. Let's give two different balance sheets for Company A:
Balance Sheet 1:
Assets: $1,000,000
Liabilities: $0
Equity: $1,000,000
Balance Sheet 2:
Assets: $1,000,000
Liabilities (bonds): $1,000,000
Equity: $0
Here is how an average financial analyst would value Company A with balance sheet 1:
"OK, we've got earnings of $100,000 in year 1 and growing at 3% thereafter. Company A's beta is 1.0, pretty average. Let's discount them at 12% for equity and subtract the growth rate of 3% and you get an enterprise value of $100,000/.09 = $1,111,111." (note that this analyst forgot to add back the realizable portion of book value, as often happens).
Here is how the same analyst would value Company A's bonds on balance sheet 2:
"OK, the 10-year T-bill rate is about 1.9% right now, the Company seems to have pretty stable earnings, corporate bond rates are low. The balance sheet is not ideal. Let's give Company A a risk premium of 3-4% for its bonds, I think the yield on these guys should be about 5%."
Company A then sells its $1,000,000 bonds with a 5% coupon rate, paying $50,000 per year in interest. Now the same analyst values the stock of Company A:
"Well, we've got earnings of $100,000 in year 1 growing 3% thereafter. Subtract $50,000 per year in debt service gives you $50,000 in earnings per year after debt payment. Company A's beta is 1.0, pretty average. Let's discount its earnings at 12% for equity and subtract the growth of 3% (some would say 6% here!) and you get a value of $555,555 (or $833,333!)."
So the same company, with balance sheet 2, created 50% more value for itself. That shows the error of the artificial risk premium for equity. In reality, the equity in balance sheet 1 has nearly the same risk profile as the debt in balance sheet 2. If the company makes money, the equity holders under balance sheet 1 will get paid just like the debt holders in balance sheet 2 will. But the equity holders in (1) will get paid a lot more because of this artificial premium on equity that should not exist. (There are many other details that can affect equity payments such as the company's ability to dilute equity or pay higher salaries to employees and executives, or its option to pay dividends. But if the company's management has integrity these risks should not be too great.) The other benefit of the equity holders is that they get to take advantage of any potential future growth in corporate earnings, while the bond holders do not. The point is that the equity under balance sheet 1 is significantly undervalued.
"No," you say. "That can't be! These analysts are well-trained. They know what they are doing. This is just an example you made up. This would never happen in the real world!"
It happens often. Take a look at Corning (GLW), one example I know off the top of my head because I have some Corning stock. I am sure that in this time of low corporate bond rates there are hundreds of examples just like Corning's.
Corning sells specialty glass for TVs, smartphones, science beakers, and other uses. It consistently earns money every quarter. It has strong profit margins. It has about $20 billion of equity on its balance sheet with lots of cash. Its management acts in the best interest of shareholders, does not waste money, and regularly pays a dividend. Corning has a few series of bonds on the market that mature at various times from now until 2021. The yield on these bonds is currently about 2.5%. That's what you'd make if you invested in them and everything went according to plan. Go here and search for GLW to verify: http://cxa.gtm.idmanagedsolutions.com/finra/BondCenter/Default.aspx
What about the equity? Oh, it's trading at just under 10x earnings. A discount rate of anywhere from 8-14% depending on how much you think earnings will shrink or grow. Yet recently Goldman Sachs of all banks downgraded Corning common stock: http://www.dividend.com/news/2013/goldman-sachs-downgrades-corning-glw/
So there you have it. Discount rate misuse continues. Fortunately this blog is not at all influential in the financial community, so hopefully I can profit off of the misanalysis of cash flows and discount rates without the market being any wiser.
