New Models for Analyzing Changes in Company Value Based on Stochastic Discount Rates

Abstract

We propose new models for analyzing changes in the value of the company using stochastic discount rates. It is shown that for the majority of the companies under study, local changes in the rate of the company value growth (percentage changes to the previous level) are not explained by the corresponding changes neither in the weighted average cost of capital (WACC), nor in the cash flows. This fact, as well as the research results by J. Cochrane, who proved that discount rates volatility is the main contributor to price volatility, became initial prerequisites for building models based on stochastic discount rates. The work presents three models built on stochastic discount rates, where cash flows are assumed to be growing with a certain trend, and the factors affecting the price of the company are described by stochastic discount factors. These models are alternative in relation to the commonly used traditional cash flow discounting (DCF) models where the free cash flow is discounted through the WACC, or the free flow to capital at the opportunity cost of equity. The first model is used to analyze the dependence of the company value on investments. It uses free cash flow subject to zero growth. The second model uses net cash flow from operating activities plus interest, minus the minimum investment subject to zero growth. The third model uses net cash flow from operating activities plus interest adjusted to taxes. This model requires to estimate the rates of the company downsizing subject to zero investment. The third model is applicable for companies with volatile investments, where it is difficult to reliably estimate free cash flow in case of zero growth. The models are designed for analysis of the factors influencing the value of the company for value-based management. Another application of the models is the evaluation of investment value of the company and the answer to the question of its possible overestimated or underestimated value. The third way to apply this model is the empirical evaluation of the weighted average cost of capital applicable to the company’s investment projects, alternative to WACC, assessed by standard methods.

Analysis of computed discount rates for the largest companies of the mineral resources sector of Russia

“…P.E. Zhukov in article [3] proposes three models for analyzing changes in company value using stochastic discount rates to measure cost factors and empirically evaluate the weighted average cost of capital as an alternative to the traditional WACC calculation. Stochastic rates in the analysis of price indicators in stock markets are also considered in the works of foreign authors [4][5][6].…”

The Problem of Determining Discount Rate for Integrated Investment Projects in the Oil and Gas Industry

“…The research presented in [19] also shows that for companies in the oil and gas industry, discount rates calculated by the WACC method may be overestimated due to inflated equity values derived from the CAMP model. According to the authors, the main problem is that the historical estimate β does not provide an adequate approximation for macroeconomic risks.…”

Assessing Value With The New Method Of Stochastic Risk Factors

“…In the classical theory of finance, expected cash flows are traditionally seen as cash flow with a constant long-term trend and a normally distributed stochastic error, and the discount rate in MM is usually determined by the cost of capital at the current time. On the other hand, it becomes apparent that the risks that investors take into account are not always reflected in the WACC or the value of equity (Zhukov, 2018(Zhukov, , 2019. The issue how investors estimates future value is insignificant in terms of the classical definition of market information effectiveness.…”

“…Recombining (2) go to the hypothesis about rational expectations of investors in the most general form (Zhukov, 2019):…”