C7.1. The measure of the required return from the CAPM is imprecise. It involves an estimate of a beta and the market risk premium. Betas are estimated with standard errors of about 0.25, so if one estimated a beta of 1.2, say, it could actually be 0.95 or 1.45 with reasonable probability. And the market risk premium is a big guess. See the appendix to Chapter 3. Fundamental investors do not like to put speculation into a valuation, and the CAPM required return is speculative.
C7.2. Inputs into a valuation more can be quite uncertain, particularly the long-term growth rate. One can get any valuation by playing with mirrors: choosing a desired growth rate to support the valuation one is looking for. Investment bankers do it when they use a valuation model to justify a valuation they seek for a stock offering.
C7.3. “Investing is not a game against nature” means that there is not a true intrinsic value to be discovered (as if it existed in nature). So the onus is not on the investor to come up with an intrinsic value. All the investor has to do is assess if the current market price is a reasonable one. That price is set by other investors, based on their analysis, beliefs, fashions, and fads. The question is: Are the forecasts in the market price justified? The game is against other investors who set the price, not against nature.
C7.4. Growth rates (in a continuing value calculation, for example), are highly speculative. Putting speculation about the growth rate into a valuation is dangerous. Always make sure that what goes into a valuation is based on solid analysis: Separate what you know from speculation.
C7.5. Growth refers to outcomes in the long-term, and the long-term is uncertain. Growth can be competed away so that, unless the firm has protection―has build a moat around its castle―it’s expected growth may not materialize. Buying growth is thus risky.
C7.6. In the long run, the growth rate for residual earnings cannot be higher than the required return otherwise the firm would have infinite value. If one thinks of the typical required return of 10%, then a 16% current growth rate must be lower in the future. Basic competitive economics tells us that firms cannot maintain superior growth in the long-term. The best guess at the long-run growth rate is the historical GDP growth rate of about 4%.
C7.7. See the answer to C7.6. Exceptional growth is usually maintained only in the short-term. Eventually growth gets competed away, so that all firms look like the average firm in the economy in the long-run.
C7.8. The degree of competition and the ability of the firm to protect itself from competition―with a brand, with proprietary technology, by adaptive behavior and innovation, for example. The period over which growth reverts to the average is sometimes referred to as the “competitive advantage period” and the speed of reversion to the average as the “fade rate.”
C7.9. Yes, growth is risky, so a high P/E stock with a lot of growth built into its price is risky. And, yes, P/E ratios are positively correlated with beta. Here are the average betas for 10 portfolios formed from a ranking on E/P (the inverse of P/E) for U.S. stocks from 1963-2006. You can see that betas are higher for low E/P (high P/E) stocks. Note also that the returns from buying stocks are lower for the E/P (high P/E) stocks: Buying growth is risky.
| E/P |E/P |Beta |Annual Returns (%) | |Portfolio |(%) | | | | 1 (Low) | -32.5 |1.38 |16.0 | | 2 |-3.3 |1.32 |10.3 | | 3 | 2.0 |1.28 |11.4 | | 4 | 4.5 |1.22 |12.8 | | 5 | 6.1 |1.14 |14.8 | | 6 | 7.4 |1.06 |15.2 | | 7 |...