Chapter 1

Understanding the Simplicity of Valuation

The constant growth equation is a simple model for valuing a stream of cash flows in perpetuity based on cost of capital and long-term growth. By using earnings as a proxy for cash flow, this simple model can estimate fair value of the stock market. Understanding how lower cost of capital and higher growth rates translate to higher price-to-earnings (P/E) ratios, thus higher valuation, and that even small changes make a big difference is one of the most important lessons from the Risk Premium Factor (RPF) Model. The Capital Asset Pricing Model (CAPM) is used to determine cost of equity capital where the equity risk premium (ERP) is a key component. Despite its importance in valuation, most methods for estimating the ERP have been unsatisfactory.

Understanding the drivers of value requires familiarity with a few basic financial concepts. The first is the time value of money. This term refers to the idea that money promised at some future date is less valuable than money in hand today. Would you rather have $100 today or in one year? Of course, you'd rather have the $100 today to spend, invest, or pay down debt. At a 5 percent annual interest rate, $100 invested today is worth $105 in a year. We call this the future value (FV).

Conversely, assuming the same rate of return, $105 in a year is worth $100 today. This is referred to as discounted value. Discounting a stream of cash flows over several periods is discounted cash flow ...