As I watched share prices fall today, I’ve been considering how my previous calculations were all based around an expected minimum return of 5% pa after tax and whether or not this is valid anymore. The reason for this consideration is that there are some defensive stocks that I believe will continue to be profitable during the oncoming fray which appear as bargains using my previous formulae.
Before discussing this further I will share how I arrived at the value of an expected minimum return of 5% for my calculations. The value of 5% was basically the sum of the Risk Free Rate (which is the rate you can invest your money with theoretically zero risk – in my case my mortgage rate) plus a generic Risk Premium (representative of risks to the economy, outside of those factored into expected future return for the specific company) plus the amount I would like to make for taking that risk after considering tax (because my investment proposition is based on the return I want to make for myself, not the IRD).
In the derivation of the value of the 5% lies the problem, which is that the Risk Free Rate has increased and is set to increase in the coming year or more; hence the cause for concern over inflation for investors. Additionally the Risk Premium has also increased to reflect the level of uncertainty and negative sentiment for the future economy. Therefore it seems obvious that shares cannot be valued using my previous calculations.
I’ve already talked about how PE is no longer a good way to value stocks because it assumes a linear, constant progression of company earnings, but as you can see, there are some fundamental components to the way PE should be used that are also falling apart because it’s harder to assign a Risk Premium and Risk Free Rates are changing and unpredictable in the term that I look to invest in (years).
There are two components to calculating value in a company using PE: Firstly calculating the PE, then calculating what PE is appropriate for that particular company.Lewis Hurst
The problem with investing in your Risk Free Rate option is that there’s also no risk of upside. This may change my financial models if we spend too long in these doldrums. Whatever the state of my modelling, it seems that I have no other course of action than to wait until the future of OCR changes becomes clearer, which will be preceded by tamed inflation; inflation being a sign of how the Risk Premium will be affected, also.