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An Improved Method For Estimating Discount Rates For Listed Company Valuation

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  • Yanfu Li

Abstract

This study offers a comprehensive overview of estimation methods for the discount rate used in company valuation, and then attempts to improve these methods. Firstly, for the cost of equity estimation method, this study improves the traditional form of build-up model by replacing its size premium with a betaadjusted size premium, so that the size premiums for firms in different size groups can be better reflected. Next, the study introduces an expanded capital asset pricing model (CAPM) which replaces the ordinary least square (OLS) beta with a shrunk beta. The beta-adjusted average size premium and the firm-specific risk premium were also added to capture unsystematic risk not measured by the traditional CAPM. In addition, this study introduces a target price-based multi-stage Gordon growth model, which adapts the consensus target price as a proxy of the intrinsic value in a manner consistent with the assumption of the basic Gordon growth model. The study continues by offering an effective solution to the estimation of cost of debt for companies above and below investment grade. The marginal tax rate and the forecasted rate on new debt issuance are recommended when estimate cost of debt. Finally, the study suggests a forwardlooking target capital structure to combine the cost of equity and cost of debt. The approach involves a three-step process to identify the possible target structure that firms are likely to adopt in the long term

Suggested Citation

  • Yanfu Li, 2020. "An Improved Method For Estimating Discount Rates For Listed Company Valuation," Accounting & Taxation, The Institute for Business and Finance Research, vol. 12(1), pages 67-79.
    • Handle: RePEc:ibf:acttax:v:12:y:2020:i:1:p:67-79
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    References listed on IDEAS

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    1. Roger G. Ibbotson & Peng Chen, 2003. "Long-Run Stock Returns: Participating in the Real Economy," Yale School of Management Working Papers ysm354, Yale School of Management.
    2. Eugene F. Fama, 2002. "Testing Trade-Off and Pecking Order Predictions About Dividends and Debt," The Review of Financial Studies, Society for Financial Studies, vol. 15(1), pages 1-33, March.
    3. Jorion, Philippe, 1986. "Bayes-Stein Estimation for Portfolio Analysis," Journal of Financial and Quantitative Analysis, Cambridge University Press, vol. 21(3), pages 279-292, September.
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    More about this item

    Keywords

    Discount Rate; Cost of Capital; Company Valuation;
    All these keywords.

    JEL classification:

    • G12 - Financial Economics - - General Financial Markets - - - Asset Pricing; Trading Volume; Bond Interest Rates
    • G14 - Financial Economics - - General Financial Markets - - - Information and Market Efficiency; Event Studies; Insider Trading
    • C10 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - General

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