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Clairvoyant Discount Rates

Robert D. Arnott, Feifei Li and Geoffrey J. Warren
The Journal of Portfolio Management Fall 2013, 40 (1) 109-123; DOI: https://doi.org/10.3905/jpm.2013.40.1.109
Robert D. Arnott
is chairman of Research Affiliates in Newport Beach, CA.
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  • For correspondence: arnott@rallc.com
Feifei Li
is director of Research Affiliates in Newport Beach, CA.
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  • For correspondence: li@rallc.com
Geoffrey J. Warren
is a senior lecturer at the College of Business and Economics at the Australian National University, Canberra, ACT, Australia.
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  • For correspondence: geoff.warren@anu.edu.au
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Abstract

In 2009, Arnott, Li, and Sherrerd asked how a clairvoyant investor—an investor who can see the future cash flows that a company will deliver to its shareholders and an eventual resale price—would have valued individual stocks. By examining past share prices in the context of subsequent dividends, the authors garnered insights into how well market prices predict future company success (impressively well) and how correctly the market prices growth versus value (impressively badly). This article reverses the analysis, computing the discount rate a clairvoyant investor must accept to justify the current price. The goal is to gain insight into the extent to which variations in expected returns may explain pricing. These “clairvoyant discount rates” fall in a distribution that sheds new light on value and size effects. A shockingly low discount rate, often lower than the cash yield, must apply for the richest growth stocks to justify their historical valuations. The size effect is not driven by a higher average return for small companies, but by a handful of extreme outliers. These results cast doubt on the notion that the size and value effects can be a result of cross-sectional differences in discount rates in an efficient market.

TOPICS: Portfolio construction, performance measurement, equity portfolio management

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The Journal of Portfolio Management: 40 (1)
The Journal of Portfolio Management
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Fall 2013
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Clairvoyant Discount Rates
Robert D. Arnott, Feifei Li, Geoffrey J. Warren
The Journal of Portfolio Management Oct 2013, 40 (1) 109-123; DOI: 10.3905/jpm.2013.40.1.109

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Clairvoyant Discount Rates
Robert D. Arnott, Feifei Li, Geoffrey J. Warren
The Journal of Portfolio Management Oct 2013, 40 (1) 109-123; DOI: 10.3905/jpm.2013.40.1.109
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    • Abstract
    • LITERATURE REVIEW
    • OUR METHODOLOGY
    • DATA AND EMPIRICAL RESULTS
    • FROM SNAPSHOT TO A HALF-CENTURY HISTORY
    • WHAT HAPPENED TO THE SIZE EFFECT?
    • CONCLUSION
    • ENDNOTES
    • REFERENCES
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