Investment Discount Rates Explained
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.
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”
“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”.