[...] The purpose of a discounted cash flow is to find the sum of the future cash flow of the business and discount it back to the present value. To do this you need to decide upon a discount rate. [...]

[...] with the normalized adjusted income you subtract maintenance capital expenditures and divide by the discount rate. I used a simple 9% in this example. I don’t bother with WACC as it is seriously flawed due [...]

[...] R is the cost of capital. The cost of capital can be a WACC or a simple discount rate assumption that I like to [...]

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.

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

[...] for the full post on discount rates. As I mentioned in the linked post, I lean very strongly towards present dollars rather than future [...]

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?

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

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.

[...] Intelligent investors monitor their companies, not the stock symbol. We understand that all companies have an intrinsic value. If you bought a great company at a discounted price and the price has now reached the intrinsic value, you could sell or hang onto it because you can fairly expect to receive a certain rate of return from your intrinsic value analysis and discount rate. [...]