hi i'm jimmy in this video we're looking
at some of the key components to coming
up at the fair value for a stock and the
big change i think we should all
consider making considering the current
economic environment
so basically when we're coming up with
the fair value for a stock well what
we're trying to do is we're trying to
come up with the present value of future
expected cash flow so to illustrate this
with a quick example let's imagine i
told you i was going to give you a
hundred dollars one year from today how
much would you give me for that one
hundred dollars today it wouldn't make
any sense for you to give me a hundred
bucks today and i'll pay you back in a
year i'll give you a hundred bucks later
because you'd get nothing out of it so a
lot of it would come down to what
required return you need
so if you needed let's say you needed a
five percent required rate of return
well you would give me you might say
jimmy i'll give you 95 bucks today but
you're gonna give me a hundred dollars
in a year you'd get about a five percent
return for that if you needed ten
percent to justify the the risk there
you know the investment that you're
making well you'd give me about 91 90
would be 90 91 i believe would be a 10
return so if you gave me 90 91 today
and i give you a hundred dollars back in
one year that would be a 10 return for
you what if you needed more what if you
needed 15
well again you would give me 86.87
somewhere in that area would get you
your 15
now it's not as simple as you saying hey
i need a
15 return it's also given the current
economic environment depends on what
interest rates are doing what other
things could you do with that money if
you had really good investment
opportunities that would return 10
while offering me the money at five
percent makes no sense so a lot of it
depends on what the other op what the
opportunity cost is that being said one
of the big changes i think a lot of
investors should consider making at this
point is to adjust their required rate
of return
this has a huge impact on the ideal
entry price for any for any investment
we're considering for pretty much any
investment that being said i want to
explain quickly how i came up with the
required rate of return on view i'm
using and how i'm adjusting that
required rate of return so the way this
would work is you'd have u.s treasuries
would be considered the risk-free rate
so that would be the lowest one that's
the least amount of risk then you get
triple a corporate bonds that is more
risky than government treasuries but
less risky than something like stocks
and then after that you might have
something like stocks so
my theory here is that i would add a
premium to aaa corporate bonds now i
didn't do this on my own i actually i
came up with this idea of reading about
buffets from buffett when buff warren
buffett ran buffett partnerships he
added a premium to corporate aaa
corporate bonds and that's what he sort
of told investors that he would be able
to return so i think it makes sense to
add a premium i was adding about four or
five percent
to this time period so in this time
period is about two and a half so i made
my required rate of return about seven
and a half percent and then as corporate
bonds started to rise well i started to
realize i'm gonna have to increase my
required rate of return so i was at
seven half what if i jump over to eight
and a half but then corporate bonds kept
going up and now they're even higher so
now for me i think a more logical number
to use is something like a nine percent
required rate of return
now people might ask why not move higher
than nine percent or why even use a
premium over bonds why not just use a
fixed rate the most common one that gets
quoted to me is either use nine or ten
percent to represent the
the long-term returns of the stock
market or
twelve and a half percent because you
want in theory a premium over the
long-term returns of the stock market my
issue with both of those answers is that
if you're going to pick a fixed number
what happens when other investments
become
better so for example trip sticking with
aaa corporate bonds this is a chart of
the aaa corporate bonds of trip the
average yield on aaa corporate bonds
going back to the 1970s and early 1980s
well in this area of course my required
rate of return of seven half percent
doesn't make any sense
in this scenario where you got interest
rates in the eight nine percent range it
probably makes much more sense to go
with something about thirteen percent
but what about when they jump up to here
again
nine percent 13 doesn't make any sense
if i can invest a risk-free investment
and get 13 14 this thing topped out
around 15
why would i possibly require my stocks
to get less than that so in this
scenario i'm increasing my required rate
of return to let's say about 19
again this is important because when we
try to come up with a fair value for a
stock well the required rate of return
that we use is very very important okay
so this is a discounted cash flow
calculator that we're putting together
we're actually building a website so if
you want to sign up to get access to
that i'll leave a link in the
description below but the point in the
context of changing our required rate of
return is that if we use a required rate
of return of seven and a half percent or
we get a fair value for metastock which
is facebook of about 298.
adjust that one number up to let's say
nine percent which i feel is a more
appropriate uh required rate of return
at this point and the fair value drops
all the way from 298 all the way down to
230. now this is important this is just
like the example where we were talking
about the hundred dollars that you would
give me if you want to get a higher
return you should pay a lower price and
this is also why i don't think it makes
a ton of sense to pick a fixed required
rate of return and then keep it there
because as the economy changes we should
expect different returns from the stock
market we say that the stock market has
averaged nine or ten percent a year
over the past let's say 50 70 years and
while that may be true
it didn't return nine or ten percent
every year to expect that return every
year would have been crazy so for me i
think it makes much more sense to pick a
premium over a less risky assets like
aaa corporate bonds if you want to pick
a different index or you want to add a
bigger premium that makes sense but then
at least as the economy changes as the
interest rates go up well our required
rate of return would also go up which
means that we would need to pay a lower
price for stocks higher interest rates
should call for lower stock prices so
the stock market falling here is very
very logical
that being said if you'd like to sign up
to get access to this website it should
be up and running over the next couple
weeks well i will leave a link in the
description below link right here and
thank you so much for sticking with me
all the way to the end of the video i
really do appreciate it thank you and
i'll see in the next video