Bridge over ocean
1 January 1977 Financial Analysts Journal Volume 33, Issue 1

Risk and Liquidity Revisited

  1. William L. Fouse, CFA

The implicit discount rate—the expected rate of total return that equilibrates current price with a forecast dividend stream—is the single most important piece of information to have about a common stock.

Risk premiums and liquidity preference premiums play a pivotal role in explaining variations in the discount rate. Although these premiums are constantly changing, the effect of changes on the structure of implicit discount rates is systematic. In particular, it is usually true that: (1) the higher the market risk in a stock, the higher the discount rate or expected return tends to be; and (2) the lower the market liquidity, the higher the discount rate or expected return tends to be.

An honest analyst would admit that nine times out of ten his own forecast of fundamentals is not meaningfully different from the consensus forecast. This does not mean, however, that only 10 per cent of his forecasts are useful. Because they are relatively more stable than the risk and liquidity premiums implicit in security prices, consensus forecasts can be used in conjunction with market prices to derive changes in the discount rate structure over time.

Read the Complete Article in Financial Analysts Journal Financial Analysts Journal CFA Institute Member Content

We’re using cookies, but you can turn them off in Privacy Settings.  Otherwise, you are agreeing to our use of cookies.  Accepting cookies does not mean that we are collecting personal data. Learn more in our Privacy Policy.