In discounted cash flow valuation, discount rates are the instruments that we use to adjust for the risk in cash flows. In practice, discount rates often take on a far greater role. Some analysts use them to bring in the quality of management, pushing down discount rates for what they perceive as well-managed firms and pushing up discount rates for poor management. Venture capitalists pump up discount rates to compensate themselves for failure risk, i.e., that many of the firms that they invest in will not make it. While these adjustments may seem intuitive, they are dangerous for many reasons: you can double count both the good and bad, you may be adjusting for risks you should not be and biasing your valuations.
Management Quality, Competitive Advantages and Discount Rates
It remains almost an act of faith in some old-time value investing circles that the rate of return that you should demand on an investment (or discount rate) should reflect the quality of its management and competitive advantages (or moats). Though this seems intuitive, it is not true for a simple reason. Management quality and moats will affect the expected earnings and cash flows, with better quality management and bigger moats delivering higher earnings and cash flows (than for firms without these qualities) but the relationship with risk and discount rates remain tenuous, at best. That is because risk has to do with uncertainty about levels, rather than levels.
To see why, consider two companies with vastly different management in the same business. Company A, with “high quality” managers in place is aggressive in its pursuit of growth while also being discriminating, a rare combination that delivers an expected operating margin of 8%, with high variability, with values ranging from 5% to 11%. Company B has a management team whose governing style is inertia, delivering sub-par margins of 3% but with much less variability (2.5% – 3.5%). In this example, company A will have a higher cost of capital than company B but with its higher cash flows, it will also be worth a great deal more. In fact, intuition leads me to believe that companies with significant competitive advantages (moats) and high barriers to entry are often more risky, since the loss of these competitive advantages will cause a much greater loss in value than for companies that are expected to tread water and earn close to their cost of capital.
Risk and Discount Rates
[drizzle]When valuing companies, you confront all kinds of risk, some related to the company and some to the macro economy, some continuous and some discrete. In my post on uncertainty, I broke risks down in different categories and the way you incorporate risk into value can depend on the type of risk. While it does seem intuitive to use the discount rate as the receptacle for all the risks that you are exposed to, it does not work very well. The reason is simple. A DCF is a going concern concept and the discount rate is designed to capture risks to a going concern, i.e., risks that cause revenues, earnings and cash flows to change over time but not truncation risk, i.e., risks that can cause an end to a company’s life. If you add on the perspective of a diversified investor looking at the going concern, the risk that is incorporated into a discount rate should only be macroeconomic risk that affects the value of the firm as a going concern and neither truncation risk nor micro/estimation risk has a place in value.
So what should be done about risks like nationalization risk or distress risk? While your discount rate may be ill-equipped to convey theses risk, they should have an effect on value and I borrow a tool from probability & statistics to capture this effect.
Decision Trees and Truncation Risk
By attaching a probability to the truncation risk and calculating the consequence, you will reduce your expected value for an asset without doing discount rate gymnastics. That is the technique that I would use to value a start-up (with a high risk of failure), a young biotech company (where the failure to get drug approval can cause it to shut down) or even a large bank with a regulatory capital problem and the possibility of an equity wipeout (see my Deutsche Bank valuation from a couple of weeks ago). If you are interested in extending your probabilistic arsenal, try this paper that I have on the topic.
What about company specific and estimation risk? Uncomfortable though it may make you to do so, when valuing public companies that are at the margin priced by institutional and diversified investors, you should let these risks pass through and use diversification as your tool for averaging risk. As for the oft-touted advice that the cash flows should be adjusted for risk, I would advice caution since many people who offer this advice seem to think that estimating cash flows across many scenarios and taking an expected value across them is adjusting for risk. It is not!
In any discussion of discount rates, distractions abound that can lead you not only away from good sense but very quickly into a morass. Here are three of the most common distractions:
- Margin of Safety: Many investors tout the margin of safety as their protection against risk. While I have absolutely no issue with building in a margin of safety into your investment decisions, as long as you recognize that there is a cost to being too conservative, I do not believe that it can be offered as an alternative to risk-adjusting the discount rate. As I understand it, the margin of safety is the buffer you build between value and price to protect yourself against your mistakes. If you are using a DCF to estimate value, you still need a risk-adjusted discount ate.
- Homework: When doing valuation, I have been sometimes told that the reason that I face risk is because I have not done my homework, and that spending more time understanding the company, its business and the management will make the risk go away. Really? So, when valuing a Brazilian company, all I have to do is spend more time with the numbers and Brazil’s political and economic uncertainties will magically vanish? I don’t think so!
- “But Warren Buffett says”: I have been told that Warren Buffett not only abhors the use of betas in valuation (and I dealt with that concern in Myth 4.2) but uses the risk free rate as his discount rate in valuing companies. Before you jump to the conclusion that he does not adjust for risk, I believe that his way of adjusting for risk is to count only that portion of a company’s earnings that is predictable. In effect, he is using what I would call “certainty equivalent” cash flows. That approach may work reasonably well with mature companies but will quickly break down for growth companies.
You can always choose another tool for estimating intrinsic value, but if you use a discounted cash flow valuation to estimate value, you have to estimate expected cash flows, adjust the discount rate for going concern risk and arrive at a value.
When doing discounted cash