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I feel like there's two schools of thought when choosing a discount rate.
1. Just use the market's estimated cost of equity, or
2. Use CAPM to risk-adjust your discount rate
There's highly esteemed names in both camps. Warren Buffett has said in the past that he just uses the market's expected return. Meanwhile, Aswath Damodaran and other academics still teach CAPM, which is a volatility adjusted way to define your discount rate. Both value practitioners are people that I highly admire.
I've been on the fence for years on this. CAPM never seemed quite right, but it also doesn't make sense to value a startup with the same discount rate as Costco.
After grappling with this problem for ages, I think I've finally solved it. Here are my thoughts...
# Why I've Moved Away From CAPM
The idea of CAPM is just a shortcut. The goal is to take a basic sentiment reading (volatility) from the general market, and assign your risk assessment based on that. In doing so, we effectively attempt to take every risk and opportunity for a company and boil it down into one metric: Beta.
The issue with this is that ***we are effectively taking market sentiment as an input into our investing process***. ***But if we want to find value, we'll need to have a view that's different from the market.***
In addition, risk changes. Overleveraged companies can pay down debt. Startups can mature and earn more stable cash flows. As investors, we have the opportunity to try to forecast these types of changes to the business. Beta may or may not change in lockstep with these adjustments to business fundamentals, but the risk profile changes regardless. We'd like to take advantage of those opportunities when the market hasn't caught up yet.
# What's the Alternative
I started using an ***expected value*** methodology.
If we can catalog the magnitude and probabilities for expected outcomes for a business, we can better assess fair value. In addition, as risks drop off or opportunities become more likely, it's very easy to adjust our valuation in lockstep.
This is an important point. ***Expected value methods allow us to be much more granular with our assessment of the business***. It requires more effort to understand the drivers of risk and opportunity, but we're rewarded with a better assessment of value and higher conviction (in my opinion).
# What About Discounting?
Yep, we still have to discount. Cash flows still lie in the future, and any payment in the future is worth less than today.
In theory, we *could* use the risk-free rate. If you've perfectly cataloged the distribution of outcomes for a business, then there's effectively no risk. I like to use a coin flip as an example. ***Even though a coin flip will lose a bettor’s wager half the time, it’s considered a riskless bet in a valuation/discounting sense.***
In practice, it's impossible to capture every potential trap door. And corporations will still always be susceptible to systemic risk...no one can escape a recession. ***So for that reason, I still use the market's expected return as my discount rate.*** Today, I assume that stands around 8%.
We still may not be 100% comfortable with the distribution we've predicted. But I think any additional uncertainty can be accounted for with a margin of safety.
This post is an abridged version of an article I wrote recently: [My Beef With CAPM](https://riskpremium.substack.com/p/why-i-dont-use-capm). Refer here for more examples and further color on my philosophy on this topic.