6.9
Discount Rates from the CAPM
The
dividend model requires us to discount future dividends.
What makes this tricky is that we know that future
dividends are uncertain, so we are really discounting expected
dividends. We
cannot simply use Treasury rates, these would only be
appropriate if there was no uncertainty about dividends.
Models have been developed to produce risk-adjusted
discount rates that are used to discount expected dividends.
One such model is the CAPM.
The CAPM,
derived by Sharpe (1964) and Lintner (1965) provides the
following discount rate:
Here,
ke is the discount rate,
rf is the risk free interest rate,
b
is the stock’s beta (i.e., sensitivity to overall market
movements), and E(RM) is the expected return from the
market as a whole.
The term inside the brackets, E(RM)-rf is
called the equity premium, and the equity premium measures the
excess return from investing in stocks over the risk free bond.
Ke is also called the expected return of the stock.
This implies that ke is a function of three inputs,
the risk free rate (usually taken to be the yield on Treasury
notes and bonds), the stock’s beta, and the equity premium.
The next example shows where you can find values for
these inputs.