Understanding the Required Return Under New Uncertainty

Abstract

Heightened world uncertainty in the past five years has posed new challenges for securities analysts and portfolio managers, particularly for equity managers using price-relative or discounted cash flow models. While they are justified in worrying about values of cash flow input to DCF models, portfolio managers must be attuned to risk factors that impact the overall discount rate and thereby market valuation multiples. A better understanding of the equity discount rate (including base and specific risk premiums) helps us explain the lackluster performance of the stock market in recent years as well as the pricing of several large-cap companies whose stock performance has been flat, despite rising profits and a wide variation in interest rates.