My big question would have to be whether or not they paid a "fair" price or they really did get it cheap. I'm not sure exactly how to go about answering that question so I'll distract myself with your "technical" question and get back around to it.
If a company has a high CROIC (like $JWN) would you give it a lower discount rate?
I think the answer to that is "not necessarily". The discount rate, in theory, is supposed to be a function of risk. Basically, standard economic theory takes only one observation from behavioral finance and builds that into their theory. That observation is that people tend to be risk averse. As a result, in order to entice someone who is risk averse to take on risk, you have to increase the potential return or expected value.
In spite of the fact that economics is a "social science" it frankly does a lousy job of dealing with social realities and even a lousier job of being a science. They're great at model building but the models don't stand up to empirical research (assuming any empirical research is even bothered with).
But here's the idea. If you give people two choices:
Choice A: Receive $100
Choice B: 50% chance of receiving $200 and 50% chance of receiving nothing.
Most people will choose A. The expected value of both choices are the same. Now if you modify the percentages and/or modify the payout so that the expected value is greater, people will become more likely to choose choice B to choice A.
So from this one kind of experiment, they built the idea that there has to be a risk premium to holding risky assets.
So in the case of your CROIC example, this reallly is taking past free cash flows and projecting them into the future. Of course this is hardly certain by any stretch of the imagination and is quite unlikely. The theory would probably tell you that in reality you have future expectations which amounts to a distribution of possible returns for which you can calculate an expected value. That distribution is where "risk" comes in.
The expected value tells you what return, on average you will get, but your actual results will vary. For example, in Choice B, the expected value is $100 but there is no possibility of receiving $100; you'll either receive $200 or nothing.
Granted, I think the whole thing is dubious for several reasons. For one, the distribution is entirely uncertain. What possible data set can we use to even use as our basis for modeling that data set with a distribution? (That's a rhetorical question; I don't know either.) So I'm not sure how we can actually fill in with a distribution to arrive at an expected value.
But even supposing we make up a distribution, I'm not sure how we can come up with a function which maps distributions to discount rates. I have no doubt Gene Fama has a function which can perform such mappings but I'm not as smart as Gene Fama. You'll have to ask him how that works.
If a company (Graeme Corp, trading at $GBD) has a croic of 20% that means that if they borrow $1 from the First Bank of Somrh, $GBD makes $1.20, right?
They would make $.20 per year on each dollar borrowed. This assumes, of course, that CROIC actually tells you how much marginal FCF one could get by investing more money. Some businesses are unable to expand without lowering their return on investment. They'll make more money but it won't be at the same rate. They might only make 10% on any future capital invested.
But I do think this quote from Charlie Munger (found here) is worthwhile:
Over the long term, it's hard for a stock to earn a much better return than the business which underlies it earns. If the business earns 6% on capital over 40 years and you hold it for that 40 years, you're not going to make much different than a 6% return even if you originally buy it at a huge discount. Conversely, if a business earns 18% on capital over 20 or 30 years, even if you pay an expensive looking price, you'll end up with a fine result.
I have no idea what discount rate one should choose here. I think the price one pays, however, will depend upon the company's growth prospects. If the firm with 18% return on capital can grow and maintain that 18%, then what price would be too much? *shrug*
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