A resource for you all to start with before I give my perspective on WACC and discount rates.  Below is a source I use to keep tabs on the implied market risk premium and average market discount rate:

Australia: http://www.market-risk-premia.com/au.html

US: http://www.market-risk-premia.com/us.html

These charts have shaped my view on market valuations and the appropriate discount to use that we all struggle with Chagsy.  According to this the Implied Market Return is 5.22% for Australia and 4.83% for the US, which is around the 5% you suggested.  BUT, is this the rate you want to use?  Technically the answer is probably yes (adjusted for beta of the stock in question), but then your question around Inflation and future interest rate expectations comes into play.  If I hold a share for the next 10 years, todays market rate of return matters little to me and my returns in 10 years’ time!

I use a rate of 10% for most of my valuations, for several reasons:

1.      I value on a long-term outlook, and on average 10% has been a close average for expected returns for markets over the long term and outside of what are historically very low interest rates that are highly likely to be much higher in 5-10 years.

2.      It’s the minimum rate of return I want in an investment.  DCF’s can be used to work out the implied rate of return in the current share price for the stock as much as the price it should be if you have a fixed expected rate of return.  So, pick a rate that works for you.

3.      Deflation of capital values as interest rates rise:  If I used the current market rate of return of 5.22% in Australia then I am assuming that interest rates stay where they are, which will give me a 5.22% return over the long run.  However, if interest rates go up (possibly to address inflation), then capital values will drop as the chart shows a higher rate of return will be required from the market (which lowers asset values to achieve those rates of return).  So you need to add a “capital deflation” (margin of safety) factor by having a higher discount rate than the market implied rate if you are thinking long term.

As I look forward to a glass or two of red tonight, some other thoughts to mull over when you next have a glass in your hand Chagsy (and others):

Inflation: To Wini’s point, this impacts us all in different ways, however as a share investor it doesn’t bother my much because I own productive assets that will appreciate in value and generate higher earnings with higher inflation.  Stagflation however is a threat to this value due to it’s impact on economic growth, but I support the Fed and RBA views that the current inflation is transitory, resulting from the significant supply and demand disruption caused by Covid and will subside as economies normalise.  I disagree with those who say we are in for another period of Stagflation like the 70’s, because the world trade is significantly freer than then, so supply and demand pressures normalise more quickly and are less locked in by restricted trade and unionised labour (due to micro and macro reforms taken around the world since then).  I have an economics major from 20+ years ago but am not a practicing economist so DYOR.

Interest Rates: The Fed and RBA don’t see any further economic stimulation offered by going to rates below zero, so they are not likely to go down, money printing levels are being used for further stimulus as needed.  The question is more “when” do rates go up and by how much.  To my mind government and private debt levels prevent this happening quickly or to a high level.  So, getting back to what was viewed as a normal rate of around 5% could take up to a decade.  See the chart I reference at the top, the green line is the risk free rate (ie interest rates), this will increase and push up rates of return required by the market (ie reduce P/E ratios), but central banks are at pains to do this slowly and in a controlled way because they know the economic carnage it will create if they do it rapidly.

Implied Market Return: Again, looking at the charts at the top – this tells us that high P/Es are fully justified because the black line (Implied Market Risk Premium) remains at relatively normal levels.  In Australia it’s currently 4.08%, at above 5% the market is generally undervalued and under 3% it is overvalued.  However, you have to remember this is backward looking, so expectations of future earnings will move this up (lower earnings expected) or down (higher earnings expected).  Add to this the expectations around future interest rates and you get the implied market return which is basically the inverse of the average market P/E ratio. 

Market View: Currently (July in the chart), the market is of the view that interest rates are remaining low, so they are not worried about inflation forcing central banks to increase interest rates.  The market view on risk is on the low side of normal, which indicates a positive view of future earnings and economic growth.  I am not sure when the chart is updated, but it’s not a tool for short term decision making in any case.

Best of luck all in finding a discount rate that works for you and remember the greatest value you get out of doing a DCF is a better understanding of the company, not the number at the end

I am locked in a fruitless battle to try and master Excel in the quest for DCF competence. After another 3 hrs of diligently entering historical data and ending up with my usual incomprehensible output, I gave the Yorkshire teabags a miss and reached for glass of warming GSM instead. It's quite cold in Brisbane at the moment.This got me pondering on a couple of factors from which my final, yet elusive, valuations are derived.

With Australia in recession, the likelihood of the RBA raising interest rates any time soon is non-existent. Consequently the risk free rate of return is going to stay very low, and thus the WACC is going to be very low. Most DCFs posted here use 10-15% as their discount, which strikes me as pretty high. Admittedly, these are often micro-cap, unprofitable companies which would no doubt struggle to attract cheaper lending. But many are not, and I wonder if a lower discount rate is applicable?

The thing about opening a bottle of red, is that one glass is rarely enough. Particularly, after nightshift.

Following on from this line of thought, does the prospect of low interest for longer suggest prolonged elevated share prices? Particularly Growth companies? And if so, are any of you positioning your portfolios to account for this?

I'm really enjoying sitting on my front deck waving a full glass of wine at the people walking their dogs at 07:30 in the morning.

I read recently that wage growth is starting to re-appear in the US, and that price increases in both goods and services are becoming more established. The Fed continues to state that inflation is transient, and that they arent even thinking about thinking about tapering QE. I wonder if inflation could be around the corner and if it beomes established in the US, whether it will be exported to the rest of the world as it has in previous years. And if so, what impact that will have on Growth stocks listed on the ASX?

Are bottles getting smaller nowadays?

This one's nearly empty. Better go to bed.

The spreadsheets can wait.