I don't think Hagstrom is far off the mark. In the 1991 Letter to Shareholders, Buffett used 10% as his discount rate in an example to find the intrinsic value of a newspaper, but at year-end 1991, the 30-yr bond rate was 7.7%. So Buffett was additing 2.3% to the discount rate at the time to do the discounting.
Remember what the discount rate is used for: it's used as the discount rate in the perpetual annuity formula, PV = C / (r - g). A perpetuity's coupons are paid yearly FOREVER, so you want to make sure the discount rate, r, accurately reflects what the discount rate will be not just now but from now until eternity.
Buffett made comments a few months ago saying that if both interest rates stayed low and ROE's stayed high, current high stock prices could be justified. But he said it's not likely that either of these conditions will continue to be true in the future, so to be on the safe side, you should jack up the discount rate. 10% is good (and even higher than Hagstrom's) because Buffett himself used it in his 1991 Shareholder letter example (see the section entitled, "Some Valuation Math.")
I understand your logic and I appreciate your reply to my message. However, you are off the mark a little.
First, the Buffett example about the newspaper valuation was not supposed to be an exact example of how he does it. He was using that as an example of how the market values stocks generally. I've read that section about 50 times and nowhere does he specifically come out and say that's how he does it or how he figures out the discount rate. I have read quotes by him, however, in which he says you should not use any risk premium, but use a margin of safety when estimating future growth in earnings. Come to think of it, even the Hagstrom book quotes Buffett as saying that. The reason Hagstrom's valuations all came out so low (i.e. for Disney, Coke, ABC, etc.) is because Hagstrom didn't cut 50% off the intrinsic value as an acceptable buy price. He just took the full I.V. using the 9% rate as the buy price, which of course was higher than the current market price of those stocks. Almost ANY stock has an I.V. higher than the market price if you do it this way. Go ahead and discount Coke's earnings out right now using a 12% growth rate for 10 years and 5% after that, and a 9% discount rate. You'll see what I mean. It gives an I.V. higher than today's market price. Would you then conclude that Coke is undervalued at 51 times earnings? Of course not. You have to discount Coke's earnings out at about 7%, and then take 50% of the I.V. as an acceptable buy price. Even then, it's overvalued.
If you try to predict earnings AND future interest rates, you're trying to do the inhuman. No one can predict future interest rates more than a few months out.
In 1991, if rates were 7.7% when Buffett wrote his piece and he used a 10% discount rate, that would be a 30% premium over the then current long bond rate. Today's long bond rate is 5.6%, and 30% above that is about 7.25%. You have to use the percentage premium he used, not the absolute number. Otherwise, the logic is flawed. So I guess maybe I should be using 7.25% instead of 7%, but again the Buffett example was not meant to be that specific.
I still say you can't predict something like interest rates, whether they'll go up or down, and so the only thing you can do is use the current rate and go off that. It's hard enough to predict future earnings. Use a margin of safety for that. If interest rates go down from here (they just might), you may be using a margin of safety on your discount rate that prevents you from buying some great stocks at bargain prices.
One of the problems with using the perpetuity formula for anything during times of very low interest rates, (such as now, as the long bond is at the lowest rates since being issued in the 70's), is that prices can quickly approach infinity. This is due to the convex nature of a bond's yield. I am sure most of you are familiar with basic bond math, so suffice it to say that it takes a correspondingly greater increase in the price of a bond to go from 6% to 5% than from 10% to 9%.
Let's say that we are now in a period where interest rates will remain permanently low, due to, say, massive global oversupply, Asia's recession, whatever. Now, if you were to use the long bond's yield of 5.537% to discount your growth rate of 5%, the prices approach absurd levels. At these rates, every dollar of earnings would be valued at over 186 dollars! The same dollar using a discount of 7% would be worth 50 dollars, still not cheap. And as rates go lower, the problem becomes worse, especially when you consider what happens if (when) rates start to rise again. These astronomically high valuations quickly plummet to earth, causing massive asset devaluations.
So, if you have a company expected to grow at 5% forever, and rates continue to go lower, how do you use this equation effectively??? Even if you use the 50% of intrinsic value method, you still are paying high prices for stocks.