Stocks Should Be Valued with a Term Structure of Required Returns

Abstract

In theory, the intrinsic value of a stock is determined by discounting the projected cash flow by a term structure of time-varying required returns. In practice, investors typically use a single discount rate, often a Treasury rate plus a risk premium. A single discount rate is a noisy proxy for the full term structure and can cause large valuation errors. If a single discount rate is used, the yield to perpetuity recommended by John Burr Williams is likely to be a better approximation to a complete term structure than are short-term rates.

TOPICS: Fundamental equity analysis, portfolio theory