 This topic has 7 replies, 4 voices, and was last updated December 24, 2022 at 12:37 pm by .

Topic

I was going through Blair’s The Ritual of Capitalization article, and I realized his equation for the effective discount rate is the reciprocal of the trailing P/E ratio, i.e., it is the railing E/P ratio. Whether you divide trailing earnings by market cap, or you divide trailing EPS by share price, you get the same thing.
While this equation is generally correct for an investment over a single period, e.g., a one year loan with a single payment at the end, does it actually fit within and advance CasP’s analytical framing? Another way of asking the question is, while CasP’s simplified discounting equation (aka the capitalization equation) is useful pedagogically, is it useful analytically? If capitalists look to the future, why would they use a trailing P/E ratio to do that? Do similar P/E ratios imply similar rates of return (aka discount rates)? (Compare, e.g., WMT and NVDA.) Is there a meaningful correlation between rates of return and trailing E/P ratios? If capitalists seek to beat the market average rate of return, which has been around 12% annualized over the last 10 years, why would they invest in AMZN or AAPL, with discount rates (aka rates of return) of 1.3% and 2.7%, respectively, as of the time Blair wrote the article? Does using the simplified capitalization equation to derive an “effective discount rate” tell us anything about the rate of return that capitalists seek and crave? Does it tell us anything about differential power, for example? (For example, if two companies have similar E/P ratios, similar market caps, but wildly different annualized rates of return, what does that imply? Different growth expectations? Different hype?)
One of the things about CasP that appeals to me is that it claims to center capitalism in finance, which is what I’ve believed it to be for quite some time. Although I previously thought about capitalism in terms of compounding, discounting is the inverse function, and the rate r must be (and are) the same for the two functions to be reversible. From that perspective, CasP rightly focuses on the premium capitalists seek, whether as profits, interest, or yield.
Unfortunately, CasP tends not to explore how financial analysis is actually done. For example, investors and financial analysts use CAPM (which is discussed in Capital as Power) along with other methodologies to develop free cash flow models. The primary use of CAPM is to derive a “differential” rate of return relative to the market broadly based on the capital structure of the firm in question. In some cases, the target rate of return for the equity component of firm(e.g., INTC) is significantly less than the SP500’s rate, sometimes it is greater (e.g., TSLA). The discount rate actually used in the model typically is the weighted average cost of capital (WACC), which weights the relative contributions and expectations of debt and equity to form a composite discount rate. Future growth calculations are done separately, and the discount rate (WACC) is applied to the predicted future earnings to reduce them to a net present value. Here is a good place to get a sense of how these models are constructed.
Despite the foregoing, I still hold out some hope that the effective discount rate analysis may be useful at the macro level, but I don’t have access to the necessary data (or if I do, I don’t know how to find it easily). One thing I was trying to do was to determine if there is any correlation between P/E ratio (or E/P ratio) and annualized rate of return of the SP500, but I could not find data expressing both on the same scale and fully aligned (e.g., monthly data for P/E ratios, annual data for rates of return, but not on the same dates).
 You must be logged in to reply to this topic.