Question

Your friend, who took finance classes , says that he has seen the stock price of Tesla go up and down like a yo-yo over the past several months. He says "Tesla is a very volatile stock, the return fluctuates a lot. Irrespective of whether the market as a whole is quiet or volatile, there is a lot of volatility in Tesla stock. This makes it very risky, and I know that higher risk means a higher discount rate. So, Tesla's discount rate will be very high."

What should I say that he's wrong?

Answer 1

Higher risk does not necessary means higher discount rate so your friend is wrong because he is offering a higher discount rate while valuation of shares of Tesla that would make the company overall estimated market capitalisation lower and it is not an effective method of valuation.

When is there is high risk,it is also interpreted in the way that it have the probability of generation of higher returns. As for Tesla it can be said that the stock has been on an ruthless upside but there are a lot of uncertainty with regards to the operations and projections.there is a high level of growth factor also associated with the earnings of Tesla ,so one should be providing a high growth rate and a moderate discount rate because the funds are obtained by Tesla at rational interest rates so the discount rates which we can use to discount the overall value of Tesla would be the expected rate of return on the cost of debt.It's not just to be discounted with the higher rate of return because it is more risky than other shares.

Stock can be volatile at time because of the good as well as the bad news.volatility can be based upon different factors like volumes and expectations, or irrational pricing of shares but that doesn't mean that higher discounting rate should be adopted in order of discounting that share.