How low rates affect intrinsic valuation calculations

This is an excellent post from Prof. Damodaran on how low government bond rates impact intrinsic valuation-- especially calculations using discounted cash flow.

Low rates artificially inflate the computed intrinsic value, by suppressing the discount rate. One clear way to avoid this pitfall is to simply use 6.67% no matter what the risk free rate is. 6.67% is approximately the rate of return of S&P 500 over a 100 year period. It would be a safe assumption that S&P 500 will not achieve 6.67% growth in the 21st century, having a higher rate provides some inherent margin of safety into the calculation.

Other option is to be very conservative and choose a static, and yet, reasonable high discount rate eg: 12% or 15%.

Of course, regardless of the discount rate you choose, never forget to apply a margin of safety factor to your valuation to come up with a target buy price.

European Debt Saga: Start of the End Game

Value investors like to buy undervalued securities, and one of the best places to find them is in a well known area of distress. The European equities, as a group, is precisely that area.

As we all know, the European sovereign debt issue has been going on for a long time, but has not shown any signs of going away. The squabbling European governments have squandered golden opportunities to make hard decisions early in the crisis to avoid catastrophe. To this day, the public discussion in places like Germany is that this is a problem created by profligate Greeks, and they should be punished. There is absolute denial that countries like Greece are actually insolvent (due to fear of contagion) and they continue to treat this as a liquidity problem. Consequently, they are giving the Greek government money while imposing austerity (read: punishment). Fixes for liquidity issues,  do not solve liquidity problems.

While this denial is going on in Germany, and rest of European countries, the problem is getting quite worse. Greece has finally reached a point where it has less than a month before it has to, most likely, default-- and since this acute public denial exists in rest of Europe, I strongly suspect, it is going to be a messy default.

I suspect that once the default happens, the European equity market will sell off in a large way. Some European equities that are cheap today, will likely become incredibly cheap. That will be the time for value investors to step in.

In the meantime, I encourage my fellow value investors to start making a wish-list of European businesses with strong balance sheets (even if it is in Euros), excellent cash flows and wide economic moats.

This may be once in a lifetime opportunity.