Black's Simple Discounting Rule

Abstract

We study the implementability of Black's (1988) elegant discounting rule. The rule overcomes thorny problems that traditional valuation approaches struggle with, namely identifying the market portfolio, measuring project risk, and assessing the market risk premium. We offer new theory, showing that the conditional mean cash flow called for in Black's rule equals a given percentile of the cash flow distribution. Moreover, we present evidence that the probability level of the percentile in question is reasonably stationary in time and across countries, and that managers typically have the information our implementation requires. Computing project and firm value with the approach we are proposing is a feasible and theoretically sound alternative to other valuation methods.

Keywords: Black, valuation, discounting, conditional cash flows

JEL Classification: G12, G31