- Laying the Foundation – Discount Rate Discussion for Value Investors
What type of person are you?
- DIY investor looking to determine what price you should pay for a stock.
- Corporate finance professional doing mergers, buyouts, or MBA students taking valuation classes.
- Also see books recommended by famous investors
This discussion of discount rates is dedicated to #1 – The everyday investor focusing on valuing public stocks to determine a good entry entry and exit point of the stock.
The details and discussion that goes into corp finance discount rates is a different beast. As a small investor, you have more leeway, and by following simple rules of thumbs, you can apply DCF stock valuations to get a good and surprisingly accurate fair value range.
In the corp finance world, the intricacies involved with calculating discount rates include matching the correct cash flow types, risk free rates, tax rates, betas, market risk premium, country risk premium, and so on.
Typically, here’s an example of the types of inputs and calculations you will have to do for WACC and corporate finance cost of capital calculations.
Also see 2017 hedge fund letters
Discount Rate / WACC calculation Required – source: Deloitte
As an individual investor, how much of this information is important?
And how much does all this data affect the fair value of a company?
Making adjustments to the unlevered beta or risk free rate will definitely change the final valuation, but that’s only important if your goal is to pinpoint it to the nearest cent.
In the stock market, such accuracy is not needed and it will only lead to biases and overconfidence.
How many people need to know and master driving skills like a race car driver?
99% of people only care about operating the features, driving safely and getting from point A to point B. Not which rubber compound and temperature provides the best grip going around 90 degree turns at 60mph or heel-toeing every gear change.
Using Discount Rates like an Everyday Investor
Before getting into the meat of the content on discount rates, here’s a look at Siri’s (SIRI) fair value using a discount rate of 7% and 9%.
To keep it simple, I’m only going to adjust the discount rate to see the effect of discount rate changes.
SIRI using 9% discount rate | source: old school value DCF calculator
With a 9% discount rate, FCF of 1.5B and all other inputs being equal, the fair value for SIRI comes out to $5.40 per share.
Change the discount rate to 7% and the fair value is now $6.63 per share. Also consider that discount rates in general operate within a tight range.
I’ve never seen a DCF model using a 30% discount rate. Conversely, I’ve never seen a DCF using a 2% discount rate. For a 2% discount rate, you might as well buy guaranteed bonds.
SIRI using 7% discount rate | source: old school value DCF calculator
When it comes to actually usable discount rates, expect it to be within a 6-12% range. The problem is that analysts spend too much of their time finessing and massaging basis points.
What’s the difference between having 7% and 7.34%?
- 7% discount rate = $6.63
- 7.34% discount rate = $6.40
If your buy/sell decision depends on a difference of $0.23, there’s something wrong.
On my part, I did the calculations lazily for SIRI in 30 seconds. It’s a simple way to get the ball rolling for further analysis and refining.
The fair value difference between a 7% and 9% discount rate is $1.23. For SIRI , I can start my initial assumption of fair value to be in the range of $5.40 to $6.63 and then continue to fine tune it from there.
We don’t believe in single fair values around here.
And this is the important point I want to make in this discount rate discussion. I am referring to discount rates relevant to investors.
There are plenty of books and material for MBA students out there to learn about discount rates, cost of capital, WACC, CAPM models and so on, but not enough practical and usable content for value investors who don’t need all the details.
Defining Cost of Capital aka Discount Rates
I use the term cost of capital and discount rate interchangeably as a public equities investor.
Investopedia explains the difference as:
The cost of capital refers to the actual cost of financing business activity through either debt or equity capital. The discount rate is the interest rate used to determine the present value of future cash flows in standard discounted cash flow analysis. Many companies calculate their weighted average cost of capital and use it as their discount rate when budgeting for a new project. This figure is crucial in generating a fair value for the company’s equity.
However, this definition boxes it in too much.
Prof Aswath Damordaran, provides one of the best approaches to wrapping your head around the terms.
Defining the Cost of Capital
There are three different ways to frame the cost of capital and each has its use. Much of the confusion about measuring and using cost of capital stem from mixing up the different definitions:
- For businesses, the cost of capital is a cost of raising financing: The first is to read the cost of capital literally as the cost of raising funding to run a business and thus build up to it by estimating the costs of raising different types of financing and the proportions used of each. This is what we do when we estimate a cost of equity, based on a beta, betas or some other risk proxy, a cost of debt, based upon what the business can borrow money at and adjusting for any tax advantages that might accrue from borrowing.
- For businesses, the cost of capital is an opportunity cost for investing in projects: The cost of capital is also an opportunity cost, i.e., the rate of return that the business can expect to make on other investments, of equivalent risk. The logic is simple. If you are considering investing in a new asset or security, you have to earn more than you could make by investing the money elsewhere. There are two subparts to this statement. The first is that it is the choices that you have today that should determine this opportunity cost, not choices that you might have had in the past. The second is that it has to be on investments of equivalent risk. Thus, the cost of capital should be higher for riskier investments than safe ones.
- For investors, the cost of capital is a discount rate to value a business: Investors looking at buying into a business are effectively buying a portfolio of investments, current and future, and to value the business, they have to make an assessment of the collective risk in the portfolio and how it may change over time.
Following on point number 3, the discount rate for value investors is your desired rate of return to be compensated for the risk.
The part that trips up many people is this:
While discount rates obviously matter in DCF valuation, they don’t matter as much as most analysts think they do. – Aswath Damodaran
Because if you actively think about how you use discount rates day-to-day, you will find that you use it like a yardstick for your rate of return.
After all, even if businesses use cost of capital as a way of raising financing or calculating it as an opportunity cost, the cost of capital has to be measured against something.
That something is a rate of return.
Nobody and no business lends or invests money without weighing what the returns will be or comparing it against some other form of investment return. Banks lend money to people at different interest rates dependent on the financial risk profile. I invest in the stock market willing to take on more risk than a savings account or a guaranteed treasury bond, for a rate of return exceeding both.
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. – Warren Buffett
The interest rate that Buffett mentions here resembles the desired rate of return.
This is a lot of talk on discount rates, so let’s make it more practical.
Calculate the Future Value
To see how discount rates work, 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 fiscal filing revealed $100 in free cash in the year 2020. With a growth rate of 10%, the company will be able to generate $110 in free cash in 2021 and $121 in 2022 and so on for the next 10 years. The total sum of the free cash until 2030 (10 years) comes out to $1,753.
The Present Value of a Company
But the sum of $1,753 over 10 years is not worth $1,753 today.
If you had two choices of receiving a total sum of $1,753 spread out over 10 years or $1,753 in one lump sum today, which would you choose?
The single payment of course.
There is time value in money. Put another way, I would not want to invest $1,753 today in one lump sum such that I 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.
This is where it’s easier to calculate backwards based on what you want. If you want a 10% return on $1,753, what do you pay today?
Something like $1,578.
In this example, your desired rate of return, or discount rate is 10%.
Therefore, it is important to figure out how much you are willing to pay today, to achieve your desired rate of return.
I’m using round numbers to hopefully make it easier to understand.
Select a Discount Rate and Discount it Back
As an everyday investor, you do not need to use complex inputs and models. I admit my method is far from perfect. But it gets better each year as I continue to refine my approach.
Prof Damodaran provides awesome tips and has written a great piece on being consistent.
1. Unit Consistency: a DCF first principle is that your cash flows have to defined in the same terms and unit as your discount rate.
2. Input Consistency: The value of a company is a function of three key components, its expected cash flows, the expected growth in these cash flows and the uncertainty you feel about whether these cash flows will be delivered. A discounted cash flow valuation requires assumptions about all three variables but for it to be defensible, the assumptions that you make about these variables have to be consistent with each other.
3. Narrative consistency: a good valuation connects narrative to numbers. A good DCF valuation has to follow the same principles and the numbers have to be consistent with the story that you are telling about a company’s future and the story that you are telling has to be plausible, given the macroeconomic environment you are predicting, the market or markets that the company operates in and the competition it faces.
Not as simple as it looks, but not as hard as it seems.
Here are some rules of thumb to help choose a discount rate which should apply to the majority of investors.
- Most likely you will use FCF as the cash flow. It is the most common FCF value you’ll come across and one that is easy for value investors.
- FCF is post tax and not adjusted for inflation (real, not nominal value).
- Therefore, the discount rate should also be considered post tax.
- e.g. if you like to use 10% returns in your calculations, you are likely thinking about a 10% pre-tax return. If you do desire a 10% return post tax, then your pre-tax discount rate is likely 11.5 to 13%. But again, if your pre-tax desired rate of return is 10%, then your post-tax discount rate should be 7 to 8.5%.
In terms of what the discount rate should be, that’s up to you.
There is no hard and fast rule for choosing a discount rate. As we’ve discussed, there is a common range of discount rates, but the final choice is based on your expectations and narrative.
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 like the example with SIRI from earlier.
But Buffett Used The 10 Year Treasury Rate!
Here’s an important side trip in this discussion.
When Warren Buffett first started to build a position in Coca-Cola in 1987, he used the treasury rate as a yard stick.
Check out these 10 year Treasury rates.
- 1980: 10.8%
- 1981: 12.57%
- 1982: 14.59%
- 1983: 10.46%
- 1984: 11.67%
- 1985: 11.38%
- 1986: 9.19%
- 1987: 7.08%
- 1988: 8.67%
- 1989: 9.09%
- 1990: 8.21%
When he started accumulating Coca-Cola, the rate was 7%, but only 2 years removed from double digits.
I wouldn’t be surprised if he was thinking that interest rates would rise again. So using a discount rate of 11%+ to start buying Coca-Cola makes total sense.
You can see how choosing and thinking through a narrative is important in choosing a discount rate.
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 a post-tax discount rate of 7-12%.
Like Buffett, I have a minimum return rate that I want and that happens to be between 7-12% in today’s world of low interest rates and dependent on the type of company.
In the example above using SIRI, I used 7% and 9% to show the difference it can make. As SIRI is a company with strong cash flows, strong ownership and a business model that can churn out money, a high discount rate doesn’t make sense.
That’s my narrative.
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. – Buffett & Munger Shareholder Meeting
If the company was a biotech with no revenue streams and only a single drug in the phase 2 or 3, the discount rate would be significantly higher.
Now it seems like the longer this gets, the more I’m confusing you… But I’ll add another piece of information anyways.
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. – Buffett & Munger Shareholder Meeting
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.
10 years ago, I regularly used a 12-15% discount rate with a 25% or 50% margin of safety.
Today, it’s in the 7-12% range with a 25% margin of safety. I would love to get back to the days when you could buy $1 for 50c, but reality bites.
Final Thoughts
As an individual investor, I’m not being pressured by peers and other analysts to conform to their models and inputs.
I have freedom to choose my discount rates based on my narrative and by keeping it consistent with my investment goals and strategy.
Please be careful that you do not match your discount rate to the valuation you want to see. But rather, you should approach the valuation and discount rate process as a way to poke and prod to discover the fair value range of a stock.
I run across people who use our Old School Value DCF model and enter numbers to match what they want to see. The outcome isn’t good of course.
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 because you’ve used some cool numbers.
Summary
- This discussion is for individual value investors. Not for corp finance, MBA or CFA study.
- Discounts WILL affect your valuation
- Discount rates are usually range bound. You won’t use a 3% or 30% discount rate. Usually within 6-12%.
- For investors, the cost of capital is a discount rate to value a business.
- Discounts rates for investors are required rates of returns
- Be consistent in how you choose your discount rate
- Don’t forget margin of safety. A high discount rate is not a margin of safety.
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Further Reading
- http://people.stern.nyu.edu/adamodar/pdfiles/eqnotes/dcfrates.pdf
- http://aswathdamodaran.blogspot.com/2015/02/discounted-cashflow-valuations-dcf.html
- http://aswathdamodaran.blogspot.com/2015/02/dcf-myth-1-if-you-have-ddiscount-rate.html
- http://aswathdamodaran.blogspot.com/2015/04/dealing-with-low-interest-rates.html
- http://aswathdamodaran.blogspot.com/2016/11/myth-44-ddiscount-rate-is-receptacle.html
- https://corporatefinanceinstitute.com/resources/knowledge/valuation/cash-flow-guide-ebitda-cf-fcf-ffcf/
Article by Jae Jun, Old School Value
