Discounting to present value

[bananow]

Hi everyone,

I have a question concerning stock evaluation and I hope I don't make a fool of myself

When valuing stock, especially in fundamental analysis, some models discount the predicted future value of the stock to present value using the yield of government bonds. My question thus is, why when discounting to present value, the discounting figure is the yield of government bonds? I mean, why specifically?

Thank you all for your posts. I really do appreciate it!!


Tomas

[dczech09]

Some people use government bonds because it is seen as a safe investment alternative to stocks.

You do not necessarily need to use bonds. You can use an expected return on investment. However developing such a figure requires estimation. So people will use government yields as a proxy.

Some other more sophisticated investors utilize arbitrage pricing theory and the capital asset pricing model to develop their proxies as well.

Its all an estimation.

[jpg7n16]

The reason is that they are comparing the value of the stock to the opportunity cost of a "risk-free" bond investment. What that means is that if you find the present value using a risk free comparison, and the risky security is actually priced at a higher price (and therefore lower return), why would you take the additional risk for less return? Essentially it gives an absolute max price for the security

Not that thats necessarily the right thing to do, just saying why they might do it.


I would personally do the discount like dczech09 mentioned, using your own required rate of return. Then you could evaluate whether the security was priced well enough for your own criteria.

If I desire 5% returns and you desire 8% returns, I will be willing to pay a higher price than you. The analysis should reflect that.