How to Discount Cashflows with Time-Varying Expected Returns




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    • Ang is with Columbia University and NBER. Jun Liu is at UCLA. We would like to thank Michael Brandt, Michael Brennan, Bob Dittmar, John Graham, Bruce Grundy, Ravi Jagannathan, and seminar participants at the Australian Graduate School of Management, Columbia University, the Board of Governors of the Federal Reserve, and Melbourne Business School for comments. We also thank Geert Bekaert and Zhenyu Wang for helpful suggestions and especially thank Yuhang Xing for constructing some of the data. We also thank Rick Green (the former editor), and we are grateful to an anonymous referee for helpful comments that greatly improved the paper. The authors acknowledge funding from an INQUIRE UK grant. This paper represents the views of the authors and not of INQUIRE. All errors are our own.


While many studies document that the market risk premium is predictable and that betas are not constant, the dividend discount model ignores time-varying risk premiums and betas. We develop a model to consistently value cashflows with changing risk-free rates, predictable risk premiums, and conditional betas in the context of a conditional CAPM. Practical valuation is accomplished with an analytic term structure of discount rates, with different discount rates applied to expected cashflows at different horizons. Using constant discount rates can produce large misvaluations, which, in portfolio data, are mostly driven at short horizons by market risk premiums and at long horizons by time variation in risk-free rates and factor loadings.