A Simple Explanation to Investment Discount Rates

February 10, 2008 | Comments (6)

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Jae Jun

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Investment Discount Rates Explained

Investment Discount Rates

Investment Discount Rates | Photo: thequantindex

Investment Discount Rates – What to look for

Investment discount rates and the concept of discounting can be very confusing to understand at first. I talk from experience.

For any budding investor, trying to understand future value and then discounting to get a present value can be quite tricky. So I’ll try to provide a simple explanation.

Let’s start with a quote from Buffett

“The value of any stock, bond or business today is determined by the cash inflows and outflows – discounted at an appropriate interest rate – that can be expected to occur during the remaining life of the asset.”

The Future Value Of A Company

You calculate the future value of a company by predicting its future cash generation and then adding the total sum of the cash generated throughout the life of the business.

This requires you to calculate a growth rate and then apply it to the company’s free cash flow.

To illustrate, let’s assume a company’s latest fiscal filing revealed $100 in free cash in 2008. With a growth rate of 10%, the company will be able to generate $110 in free cash in 2009 and $121 in 2010 and so on for the next 10 years. The total sum of the free cash over 10 years comes out to $1,753.

That is, the sum of the cash flow over 10 years is $1,753.

The Present Value Of A Company

But the sum of $1,753 over 10 years is not worth $1,753 today. There is time value in money. I would not want to invest $1,753 today in one lump sum such that I will receive $1,753 over 10 years.

That is an investment return of 0%.

I want to buy that $1,753 for an amount where I will be getting a satisfactory return out of my investment.

For example, when people pool their money together for a real estate investment, they may pay $100,000 today to get a piece of a $1,000,000 investment in a resort. In this example, they are assuming that $1,000,000 is worth $100,000 today.

Therefore, it is important to figure out how much you are willing to pay today, in order to receive $1,753 over the 10 years.

Select a Discount Rate and Discount it Back

There is no hard and fast rule for choosing a discount rate. You do not need to use fancy financial formulas to calculate it. Keep it simple.

If you choose to use a high discount rate such as 12% or 15% to discount the future cash, it just means you are willing to pay less today for the future cash.

But an important point to understand is that

“You can’t compensate for risk by using a high discount rate.”

If 15% was used to discount $1,753, you would only be willing to pay $1,524 in today’s money for $1,753.

On the other hand, using a 9% discount rate would give a value of $1,608 for the $1,753.

You can see how using a high discount rate will give a lower valuation than a low discount rate.

But Buffett Used The 10 Year Treasury Rate!

Yes, Buffett did use the treasury rate when he invested back in the day.

But, Buffett was using a rate that was equal to a risk free return which was very high. Had he put his money in 10 year treasury bonds, he would have earned around 8.85% at that time without any risk.

If you used the risk free rate treasury rate as a discount rate measuring stick, you would only be discounting the future value by around 1-3% at most.

The question is, do you want an annual return of 3% from your portfolio? Obviously no.

Buffett’s choice to discount by the treasury rate was his minimum required return. He also used the treasury rate as a measuring stick for all businesses, rather than assigning a different rate for different businesses.

“In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value – in our case, at the long-term Treasury rate. And that discount rate doesn’t pay you as high a rate as it needs to. But you can use the resulting present value figure that you get by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of measurement across all businesses.”

So What Is A Good Discount Rate?

I like to use something in the range of 9-12%.

Like Buffett, I have a minimum return rate that I want and that happens to be between 9-12% depending on the type of company. I could seek 20% or even 30% but that will just make my search so much harder and limited because I will be trying to buy $1,753 for $1,349. (It may look feasible when the numbers are small, but when we are talking in billions, it comes out the same as buying $17.5 billion for $13.4 billion today. A difference of nearly $5 billion!)

In my example of Apple I used a 9% discount rate. Why not 15%?

“If we thought we were getting a stream of cash over the thirty years that we felt extremely certain about, we’d use a discount rate that would be somewhat less than if it were one where we expected surprises or where we thought there were a greater possibility of surprises.”

Since AAPL is a cash cow, has a good business with a fairly wide moat and not expected to go bankrupt, I used a 9% rate. Had I examined WalMart, Coca Cola, Johnson & Johnson or Microsoft, I would also have chosen a rate of 9% since historical data provides evidence of steady predictable cash growth and so future estimates would be much more predictable than the likes of an IPO or startup.

However, the important aspect is not deciding upon a discount rate, but in being logical and reasonable about cash projections.

“Don’t use different discount rates for different businesses…it doesn’t really matter what rate you use as long as you are being intellectually honest and conservative about future cash flows.”

Don’t Forget Margin Of Safety

Whatever rate you choose, never forget to apply a margin of safety because no one can accurately predict the future. But note that a high discount rate may warrant a lower margin of safety but that is up to the investor.

Personally, I use a 12-15% discount rate with a 50% margin of safety. For a majority of my investments, I want a minimum of 15% annual return and I want to to be able to buy $1 for 50c, thus the 50% margin of safety principle.

This eliminates 95% of investment opportunities but it also reduces my risk of losing a lot of money in 95% of my investments . However, for huge, stable institutions, I tend to use 9% with 50% margin of safety.

Final Thoughts

Don’t justify the purchase of a company just because it fits the numbers. Don’t fool yourself into believing that a cheap company will yield good returns. A bad company is a bad investment no matter what price it is. look closely at the Investment Discount Rates and figure it out for yourself.

I love how Charlie Munger explains that

“a piece of turd in a bowl of raisins is still a piece of turd”

and

“there is no greater fool than yourself, and you are the easiest person to fool.”

Let’s not fool ourselves. Exercise your options. Not a call or a put, but a “NO”.

  • J

    Not entirely sure why anyone would use a 15% discount rate instead of just using the risk free rate, namely 3 or 4% to compensate interest rates and basically 4% for 10 year bond treasury yield…hence 8%’ish.

    The cash flow is where you put your return, not the discount rate?

    Simply (say you’re buying 2 years worth of cash flow to keep this short)…
    1st yr – $2000 (after analyzing the business and its operations and its environment, you think it’s reasonable that they will grow 15% in the second year)
    Fine, PUT IT IN THE CASH FLOW. ($2000 x 15% = $300)
    2nd yr – $2300
    NOW, discount that year back by the 8% risk free rate ($2300 / (1.08)^2) = $1971.87 (rounded down)

    So Year 1 and 2 cash flow today is worth $2000 + $1971.87 = $3971.87

    Arguably, the problem is people don’t know how to do what they’re trying to do. Probably, you ought to be buying a business you can actually know how the cash flow is going to look like the future. If you aren’t sure about what cash flow in the second year is going to be approx., you probably shouldn’t even do the analysis. OF COURSE, you could have just as easily (and probably it’s more accurate) to say “Ya, I imagine 15% growth in second year is reasonable, but just to be safe, it could be between 13% and 15%”. Fine. So simply then discount back at 8% both numbers (which would be $2260-$2300)…now you have a range.

    The point is though, there’s no point in messing with the discount rate. The turd in the bowl of cash flow is still a turd if you don’t get it right.

    SO NOOOOW MARGIN OF SAFETY COMES IN.

    Depending on whatever you want to use – 25%, 50%, 75%…if you had any confidence in your cash flow analysis whatsoever…if we use the $3971.87 cash flow 2 year figure, the MOS gives us the value of the cash flow as $2978.90, $1985.93, or $992.97 respectively.

    But if we were that sure about our cash flow projection for year 2 above, we wouldn’t even need a large margin of safety…because margin of safety is to compensate for what we don’t know.

    In any case, the last step is simply divide those respective MOS values by the shares – and buy if the price is at or below those figures respectively.

    But I’d actually like to get your thought about this. Do you agree or disagree with what I typed above? Does it make sense or not? Ultimately, the argument is “but we end up at the same place at the end of the valuation”…but it seems that if one if discounting cash flow figures by 15% instead of the risk free rate – that individual probably doesn’t really know what they’re trying to do. Because if they did, they’d simply conservatively put thought into the cash flow figure each year, and the conservative growth of that figure…and then do the rest of the steps.

    I imagine Buffett bought coca cola at 8.85% 10 year treasury in 1988 …and not 15%…for this specific reason. Because he knew what he was doing. He knew how to estimate the cash flows conservatively.

    And no one says you have to buy if the figures don’t come out right. You simply wait until the price meets your conservative cash flow figures.

    (P.S. The one thing I left out here is the value of everything BUT the cash flow, that you add to the cash flow figure…namely the shareholders value if the business was to liquidate today. This message is long enough already, but it would require probably recasting the current balance sheet [i.e. cash at 100%, Inventory maybe at 60% blah blah blah] – add that to the intrinsic value/cash flow figures – you got the Total Value of the Business today.)

    Again, let me know if I’m not making sense.

  • J

    Just realized for the analysis I put ($2300 / (1.08)^2)

    That should have been ($2300 / (1.08)) WITHOUT the power 2. So, use your imagination for the calculations.

  • http://www.oldschoolvalue.com Jae Jun

    Hi J. Nice name :)

    I’ll to keep it short and to the point so its easier to understand.

    1. Discount Rates
    What I didn’t go over very well in this post is the relevance of the discount rate to the investor.

    What is a discount rate? It’s a rate of interest that would make an investor indifferent between present and future dollars.

    The discount rate is very different to the cash flow return.

    If you believe a 8% rate of interest for the future dollars is adequate, that is entirely up to you. I lean very strongly towards present dollars rather than future dollars. In other words, I use a high discount rate because I prefer the certainty of the present cash rather than the uncertainty of the future.

    On the other hand, other investors may prefer to bet that the future will play out like they imagined, thus making future cash flows equally valuable to today’s cash flow.

    Also, there is no single correct discount rate, and I don’t believe you can just use one discount rate for all companies. For simplicity sake of my posts, I just use 15%, but depending on the type of company, the discount rate should vary.

    A company like Coca Cola will have a much stabler future cash flow than a tech company. Thus the future cash of Coca Cola can be considered to be just as good as today’s cash.

    The tech company however, should you choose to perform a NPV, should emphasise today’s earnings rather than future earnings and should therefore require a higher discount rate.

    2. Shareholders value and total business value.
    I’m not quite sure what you meant in your comment, but I’ll take a stab at it.

    Total business value depends on how you look at the business. E.g. inventory full of laptops wont be worth much when sold or liquidated, so defining the value of invetory at 100% of its value is quite flawed. If inventory was raw materials, it would be worth much more than computers sitting on shelves.

    This also applies to machinery and other tangible assets. An old steel mill may be worth less than its stated value because others probably wont have use for its old and outdated technology.

    Agree, disagree?

  • Brian

    Hi Jae,

    Great website – was going through some of the old articles trying to understand the spreadsheets better (we just purchased the premium version). Looks like the first image in this post isn’t linking correctly. Just heads up.

    -Brian

  • http://www.oldschoolvalue.com Jae Jun

    Thanks for letting me know Brian.

    Seems like I lost the file during my webhost transfer and I don’t have the original file anymore. Will have to remove the image.

  • http://www.businessmaninvestor.com businessmaninvestor

    I can see the “eternal debate” on considering which value component for the things OTHER THAN the future cash flows was touched on in the discussions above. My view on this matter has been very much influenced by this question: past cash flows (less dividends and buybacks) must have accumulated somewhere in the balance sheet, and this accumulation should be a component in the DCF model. In determining this, I make use of the “cash hoard” concept. It’s somewhat similar to the concept of shareholder’s equity; cash hoard, however, focuses and puts great weight on liquid, marketable assets after deducting all debt (it doesn’t give any weight on capex assets and trade assets such as receivables and inventory, etc. we’re just being bias on “cash” assets) See my post about it here: http://www.businessmaninvestor.com/2011/08/corporate-cash-hoard-theory.html I’d love to hear your comments. Thanks!

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