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Best Required Return for Investors to Use? - YouTube
Channel: Learn to Invest - Investors Grow
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hi i'm jimmy in this video we're looking
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at what we should use for our required
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rate of return for investments and even
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what required rate of return is the best
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required rate of return to use
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now i actually in the later half of this
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video i tested out whether or not
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discounted free cash show really helps
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us outperform the stock market but we'll
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come back to that in a minute but
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basically picking the correct required
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rate of return or picking a good
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required rate of return is crucial
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because this helps us identify where we
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should buy whatever stock we might be
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interested in so here's what i mean so
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this is our discounted free cash flow
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calculation using johnson and johnson
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stock as our test company this is going
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to be our sort of case study now these
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analyst estimates down here well these
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are actual estimates for free cash flow
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coming from a handful of analysts we can
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see how many analysts are contributing
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to each cash flow projection well if we
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discount our free cash flow estimates by
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our required rate of return the one that
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i've chosen is seven half percent well
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we get a fair value of johnson and
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johnson's stock of about 211 bucks per
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share now i know finding analyst
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estimates can be tricky and that's
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actually one of the reasons we're
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building this website where we can we
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will have this data available and
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similar functionality and that you can
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just punch in the ticker it'll
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automatically pull down whatever the
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analyst estimates are for free cash flow
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or revenue and then
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it will kick out what the fair value of
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that stock is we expect to have the
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website up up and running in about six
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months or so so that's the point of the
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website to help you calculate the fair
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value very very quickly but we still
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have to choose a required rate of return
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that's sort of the point of this video
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that's how this video fits into this
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whole thing now in the meantime while
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the website's getting built well we're
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actually we have a private investing
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community where we do weekly live
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streams and one of those live streams we
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use this spreadsheet this is a
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spreadsheet i built to give to the web
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developers to show them where we're
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trying to go with this as far as
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functionality is concerned hopefully
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they make it looking look even better
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than this but we get the point in those
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live streams we use this spreadsheet to
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calculate the fair value of a bunch of
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stocks that the community gives to us so
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if you were to sign up for access to
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this website today
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you'll get access to the to the
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community which is over on discord and
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the private live streams but the good
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part is that the price whatever you sign
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up for today will never go up on you so
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once the website is up and running again
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in about six months or so well you'll be
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locked in at the price you're paying
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today and that will never ever go up on
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you i will leave a link in the
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description below as to how to sign up
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for the website and the community in the
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live streams and all of that okay now
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back to the required return so we can
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see here that instead of using seven and
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a half percent well if we used 10
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well the price we would need to pay
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would be less than 140 bucks per share
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and if we wanted 12 and a half percent
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well we'd have to pay less than 104
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bucks per share and if we think about it
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this is logical if we want a higher
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return a logical way to get a higher
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return is to pay a lower price for the
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same in this case the same stock now if
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we don't want to pick an individual
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number what most textbooks tell us to do
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is to use something like the weighted
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average cost of capital for each company
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it's different it depends on the company
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and it changes for every company
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this right here is the current weighted
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average cost of capital for our case
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study here now i did a whole video on
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how to calculate the weighted average
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cost of capital and i'll leave a link to
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that video in the description below okay
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so that's the basics of where the
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numbers come from and how they affect
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what we should consider paying for each
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stock that we're researching but now the
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real question is which one works the
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best clearly that depends on a few
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different things how much of do we need
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our portfolio to return for us how much
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are we willing to risk those are two
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very basic examples of some questions we
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would ask ourselves now one of the
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questions that i get a lot is why am i
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using required rate of return of seven
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and a half percent isn't that too low i
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mean if the stock market is returned
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let's say on average 10 a year
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why would i have a required rate of
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return that's less than that now i
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actually have an answer to this so my
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seven and a half percent required rate
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of return is about five percent higher
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than the average
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aaa corporate bond rate so i figure it
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makes sense for us to
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require a premium over an investment in
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bonds if we're going to invest in stocks
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we should return more than we would get
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if we invested in bonds i picked five
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percent over bonds because that's about
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what warren buffett used
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as his hurdle rate back when he ran
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buffett partnerships
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so he had a uh rate that he said he
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could have earned at least this amount
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and he had it was about it was a few
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percentage points higher than the aaa
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corporate bond rating right now the aaa
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corporate bond interest rate is about
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two and a half percent hence the seven
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half percent that's five percent higher
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and if we're curious if we look at the
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corporate bond rate the triple a
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corporate bond rate going back to 1971
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well this is what the moody's
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aaa corporate bond interest rate has
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looked like going back the past 50 years
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now i've found many investors have come
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to me and said something along the lines
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of uh you know what i won't accept any i
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will the minimum i will ever use is a 12
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and a half percent required rate of
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return and on one hand that's logical it
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is logical today but is that the highest
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interest rate we'll ever use is that the
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highest required return we'll ever use
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what if it was back in this time period
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well in that case it wouldn't make any
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sense to use a 12 and a half percent
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return my point is that if we're picking
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a hard number just to pick a hard number
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i think it makes more sense to tie that
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to something otherwise things can change
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from a macroeconomic perspective but now
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sticking with today the funny part about
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this uh the pushback that people give me
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about using seven half percent is that i
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actually don't disagree with 12 and a
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half percent from a required return
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perspective
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in fact the average bond rate through
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the past 50 years has been on average
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about 7.3 percent add my 5 premium to
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this whole thing and when we end up with
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a average average required return of
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about 12 and a half percent through this
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time period 12.3 but here's why i prefer
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to use my method of a premium over the
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triple a corporate bond rate instead of
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using a fixed 12 and a half percent rate
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and that's because i like to add a
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margin of safety to my calculations so
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over on our current website here well
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one of the features that we will be
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including in the website is the ability
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to add a margin of safety calculation to
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our investment analysis and basically
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this house this allows us to adjust in
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this case our 211 number if we said all
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right what does that work how does that
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number look if we had a 10 margin of
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safety or 20 or 15 or whatever number we
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decide to add to it basically what this
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is is the buffer we want to add that
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what if this calculation isn't exactly
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correct let's add a margin of safety to
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that so we buy it in theory below that
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margin of safety below our calculation
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of fair value now i prefer the margin of
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safety method because it allows us to be
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a bit more adaptable to each situation
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so let's say we're analyzing a company
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that has very little investment risk
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very little business risk or maybe not a
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little business risk but it has less
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business risk than another investment
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well we could add a smaller margin of
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safety if it has what we perceive to be
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less risk what if a company on the flip
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side has a lot more risk well
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you could add a wider margin of safety
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if we're using let's say hypothetically
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12 and a half percent no matter what in
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fact some stocks the less risky stocks
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you may never be able to invest in now
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like i mentioned before another option
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is to use the weighted average cost of
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capital so
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if we were to use the weighted average
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cost of capital well that essentially
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has the volatility of the stock
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baked into the whole thing it also has
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the risk-free rate generally the 10-year
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treasury has that baked into the
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calculation so that is essentially a
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premium over the 10 over the risk-free
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rate plus a twist for some volatility so
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if we have no idea of what required
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return we want to use we should just use
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the weighted average cost of capital
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this is a tried and tested method and
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generally works fairly well now i'm
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actually analyzing them i've actually
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been doing a study recently where i'm
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analyzing the effectiveness of discount
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of free cash flow and one of the tests
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that i've already performed
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is on johnson and johnson
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now i'll be doing a lot more of these
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tests on the live stream so if you're
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curious come sign up for that and i
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actually already showed the private live
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stream some of the results of this test
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but basically what i did is i took free
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cash flow going out the next few years
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going as far back as i could and i
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discounted those numbers back to the
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last day of each year and they compared
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it to compare the fair value calculation
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to the current price of that stock on
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that day our calculations of fair value
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are the blue lines on this chart ideally
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we only buy the stock when the stock the
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our calculation fair value is above the
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current price so it's trading at some
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sort of discount if we were to consider
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some sort of margin of safety well we'd
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want a wider discount now we can see
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with this chart if we used a 10 12 and a
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half percent required rate of return for
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johnson and johnson if we used it
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through this entire time period well we
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never would have had the opportunity to
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buy it what about ten percent again we
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never would have had the chance to buy
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it what about if we use seven and a half
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percent well here at least with seven
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and a half percent we'd have some
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opportunity to buy it
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but i could easily make the same
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argument that seven half percent makes
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sense today because of the where the
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corporate bond rate is but it wouldn't
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have made sense many years ago so let's
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skip right to the weighted average cost
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of capital now this one was a bit tricky
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to calculate so i want i only went back
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about the past 20 or so years but we can
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see that the concept still held up quite
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well with the weighted average cost of
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capital we had plenty of times to jump
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in and buy the stock and those stu the
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stock would have performed quite well in
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fact the performance if we bought only
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one was trading at a discount to our
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calculation of fair value well we would
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have drastically outperformed the stock
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on the years that we didn't buy it that
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way so if we bought it when it was
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overvalued you would have underperformed
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you bought it was undervalued we would
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outperform just as we would expect now
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i'm trying to test this on more and more
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companies for example here's what
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microsoft's fair value looks like
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compared to the stock price from each
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individual year now this again goes back
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about the past 20 years now what if we
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bought this stock and we overpaid here
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back when the stock price was way too
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high compared to discounted free cash
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flow well our average return over that
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time period would have been about 16
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per year not bad but if we waited for
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microsoft stock to become undervalued
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and we didn't buy it until here until it
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was actually undervalued back in about
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2011 or so well the average return jumps
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from 16
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to more than 31
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per year so clearly using the weighted
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average cost of capital works well
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which is why all the textbooks say that
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we should use it so unless we have a
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logical reason to use a different
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required rate of return i think it makes
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sense for most investors to start with
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the weighted average cost of capital and
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then adjust from there and this is one
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of the primary reasons we're going to
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have this on the website so we could do
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the quick calculation for you we don't
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have to you don't have to worry about
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trying to come up with those numbers now
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one of the things that i like to do is
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to use my own required rate of return
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but then take a quick quick peek at the
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weight of average cost of capital to see
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if it helps or hurts
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our investment story do we want to
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invest in it because the weight average
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cost of capital money might sway us one
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way or another so for the upcoming
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website i will leave a link in the
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description below so you can sign up for
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that
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thank you so much and i will see you in
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the next video
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