Clairvoyant Discount Rates

Posted: 8 Feb 2017

See all articles by Robert D. Arnott

Robert D. Arnott

Research Affiliates, LLC

Feifei Li

Research Affiliates, LLC

Geoffrey J. Warren

Independent

Date Written: November 1, 2013

Abstract

In 2009, Arnott, Li, and Sherrerd asked how a clairvoyant investor—an investor who can see the future cash flows that a company will deliver to its shareholders and an eventual resale price—would have valued individual stocks. By examining past share prices in the context of subsequent dividends, the authors garnered insights into how well market prices predict future company success (impressively well) and how correctly the market prices growth versus value (impressively badly). This article reverses the analysis, computing the discount rate a clairvoyant investor must accept to justify the current price. The goal is to gain insight into the extent to which variations in expected returns may explain pricing. These “clairvoyant discount rates” fall in a distribution that sheds new light on value and size effects. A shockingly low discount rate, often lower than the cash yield, must apply for the richest growth stocks to justify their historical valuations. The size effect is not driven by a higher average return for small companies, but by a handful of extreme outliers. These results cast doubt on the notion that the size and value effects can be a result of cross-sectional differences in discount rates in an efficient market.

Suggested Citation

Arnott, Robert D. and Li, Feifei and Warren, Geoffrey J., Clairvoyant Discount Rates (November 1, 2013). Journalof Portfolio Management, Vol. 40, No. 1, Fall 2013, Available at SSRN: https://ssrn.com/abstract=2913298

Robert D. Arnott

Research Affiliates, LLC ( email )

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Feifei Li (Contact Author)

Research Affiliates, LLC ( email )

620 Newport Center Dr
Ste 900
Newport Beach, CA 92660
United States
949-325-8753 (Phone)
949-325-8953 (Fax)

HOME PAGE: http://researchaffiliates.com/index.htm

Geoffrey J. Warren

Independent

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