How To Determine A Discount Rate

How To Determine A Discount Rate

How To Determine A Discount Rate

As I mentioned in Value Investing 101: The Time Value of Money, interest rates are determined by a combination of:

  1. The asset’s risk
  2. The asset’s liquidity
  3. The asset’s maturity
  4. The expected inflation rate
  5. The “risk-free rate”

It’s easy to see how – academically – these five determinants can drive interest rates, but how can we actually determine the interest rate (that is, discount rate) we use in our Discounted Cash Flow analysis?

A business school professor would tell you to use the Weighted Average Cost of Capital, or WACC.

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Weighted Average Cost of Capital (WACC)

A company finances its assets by using either debt or equity. The WACC is the cost of the company’s debt (interest payments) and the cost of the company’s equity (shareholders’ required return), both of which are weighted proportionately to the company’s overall capital structure. Therefore, a company’s WACC is the overall required return that a firm must achieve to satisfy both its debt holders and its shareholders.

As an example:

Suppose that lenders require a 10% return on the money they have lent to a firm, and suppose that shareholders require a minimum of a 20% return on their investments in order to retain their holdings in the firm.

On average, then, projects funded from the company’s pool of money will have to return 15% to satisfy debt and equity holders. The 15% is the WACC.

If the only money in the pool was $50 in debt holders’ contributions and $50 in shareholders’ investments, and the company invested $100 in a project, to meet the lenders’ and shareholders’ return expectations, the project would need to generate returns of $5 each year for the lenders and $10 a year for the company’s shareholders. This would require a total return of $15 a year, or a 15% WACC.

The actual calculation for WACC is:

WACC = (E/V) x Re + (D/V) x Rd x (1 – T)


Re = Cost of equity
= Expected return of the asset as determined by the Capital Asset Pricing Model (CAPM)
= risk-free rate + beta of the security x (expected market return – risk-free rate)

Rd = Cost of debt (i.e. interest rate on the debt)

E = Market value of the firm’s equity
D = Market value of the firm’s debt
V = E + D = Total market value of the firm’s financing (equity and debt)

E/V = % of financing that is equity
D/V = % of financing that is debt

T = Corporate tax rate

You can skip the algebra and use one of these online calculators here and here if you want.

If WACC seems very complicated to you, don’t worry because (a) it is and (b) it has several key flaws, so you don’t have to use it (Warren Buffett doesn’t).

What flaws?

1. More debt results in a lower WACC… which means a less risky investment?

Let’s say you had a company with a 10% cost of equity and a 10% cost of debt. Because of the (1 – T) tax shield, the WACC would not be 10%… it would be lower than 10%. This means that the more debt a company has, the lower its cost of capital will be due to this tax shield, which ultimately results in a higher valuation for the company’s stock (remember: a lower discount rate results in a higher valuation).

According to WACC, more debt means a less risky investment and therefore a higher valuation.

This clearly doesn’t make sense. If I showed you two companies that are equal in every aspect except that Company A has $0 debt and Company B has $50 million of debt, you would say that Company A is less risky. WACC says the opposite.

2. WACC uses beta, a measure of volatility, to determine a stock’s risk

In order to calculate the cost of equity in WACC, you use the Capital Asset Pricing Model (CAPM). The CAPM says that the expected return on a stock (the firm’s cost of equity) is equal to the risk-free rate plus the equity market premium adjusted for the riskiness of that individual stock. This individual riskiness adjustment is done by multiplying the equity market premium by what is called “the stock’s beta.”

Beta is supposed to measure risk by comparing a stock’s volatility to the entire market. The volatility of the S&P 500 is usually used as the base and is given a beta of one. Any stock with a beta above one is said to be more volatile and therefore more risky than the market, and a stock with a beta of less than one is less volatile and therefore less risky than the market.

But as Warren Buffett notes in his 2014 Berkshire Hathaway Shareholder Letter, risk is not equal to volatility:

Stock prices will always be far more volatile than cash-equivalent holdings. Over the long term, however, currency-denominated instruments are riskier investments – far riskier investments – than widely-diversified stock portfolios that are bought over time and that are owned in a manner invoking only token fees and commissions. That lesson has not customarily been taught in business schools, where volatility is almost universally used as a proxy for risk. Though this pedagogic assumption makes for easy teaching, it is dead wrong: Volatility is far from synonymous with risk. Popular formulas that equate the two terms lead students, investors and CEOs astray.

Now take as an example Stock A and Stock B. Stock A returns 25.0% in Year 1 and 40.0% in Year 2. Stock B returns -0.5% in Year 1 and 1.0% in Year 2. The stock market returns 10.0% in Year 1 and 12.0% in Year 2. Stock A’s beta would actually be much higher than 1 and Stock B’s beta would be much lower than 1, implying that Stock A is more risky than Stock B.

Not only does the beta result in a wrong conclusion about the riskiness of Stock A and Stock B, it also bases that conclusion on past price data, which says very little about the future value of a stock. As Buffett says: “If past history was all there was to the game, the richest people would be librarians.”

Buffett also had this to say at the 1998 Berkshire Hathaway shareholder meeting:

Don’t worry about risk the way it is taught at Wharton. Risk is a go/no go signal.

Simply put, risk is not volatility. Risk is the probability of losing your investment.

So What Discount Rate Should We Use Instead of WACC?

There is a lot of debate about what discount rate Buffett uses, and the man himself has given conflicting information on the matter over the years. But I think this exchange from the 2003 shareholder meeting sheds the most light on the issue:

Buffett: Charlie and I don’t know our cost of capital. It’s taught at business schools, but we’re skeptical. We just look to do the most intelligent thing we can with the capital that we have. We measure everything against our alternatives. I’ve never seen a cost of capital calculation that made sense to me. Have you Charlie?

Munger: Never. If you take the best text in economics by Mankiw, he says intelligent people make decisions based on opportunity costs — in other words, it’s your alternatives that matter. That’s how we make all of our decisions. The rest of the world has gone off on some kick — there’s even a cost of equity capital. A perfectly amazing mental malfunction.

Buffett: 10% is the figure we quit on – we don’t want to buy equities when the real return we expect is less than 10%, whether interest rates are 6% or 1%. It’s arbitrary. 10% is not that great after tax.

Munger: We’re guessing at our future opportunity cost. Warren is guessing that he’ll have the opportunity to put capital out at high rates of return, so he’s not willing to put it out at less than 10% now. But if we knew interest rates would stay at 1% we’d change. Our hurdles reflect our estimate of future opportunity costs.

For Warren Buffett and Charlie Munger, everything is a function of opportunity cost – which is the return of your next best investment option. Buffett says this is at least 10%, which is “not that great after tax.”

What is your opportunity cost?

Well, everyone has the opportunity to buy a low cost index fund that tracks the entire stock market, so everyone’s opportunity cost should be the return of the S&P 500.

The S&P 500 has had a 9.60% annualized return for the past 50 years. However, if you are an active investor then you will have to sell your investments every once and a while. The maximum long-term capital gains rate in 2016 is 20%. Therefore, you need a 12.0% pre-tax return in order to beat the stock market after taxes.

So, your discount rate – according to Buffett’s and Munger’s principles – should be 12.0%.

Do you agree? Disagree? How do you determine a discount rate to use? Let’s hear it in the comments below.

By the way, the drawing for the $1.5 billion Powerball lottery is tonight. Do you know the odds?

It’s 1 in 292 million! You’re 25x more likely to get bitten by a shark, 246x more likely to be struck by lightning this year, and 23,376x more likely to make a hole in one next time you go golfing.

As Lloyd Christmas might say…

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Ben Graham, the father of value investing, wasn’t born in this century. Nor was he born in the last century. Benjamin Graham – born Benjamin Grossbaum – was born in London, England in 1894. He published the value investing bible Security Analysis in 1934, which was followed by the value investing New Testament The Intelligent Investor in 1949. Warren Buffett, the value investing messiah and Graham’s most famous and successful disciple, was born in 1930 and attended Graham’s classes at Columbia in 1950-51. And the not-so-prodigal son Charlie Munger even has Warren beat by six years – he was born in 1924. I’m not trying to give a history lesson here, but I find these dates very interesting. Value investing is an old strategy. It’s been around for a long time, long before the Capital Asset Pricing Model, long before the Black-Scholes Model, long before CLO’s, long before the founders of today’s hottest high-tech IPOs were even born. And yet people have very short term memories. Once a bull market gets some legs in it, the quest to get “the most money as quickly as possible” causes prices to get bid up. Human nature kicks in and dollar signs start appearing in people’s eyes. New methodologies are touted and fundamental principles are left in the rear view mirror. “Today is always the dawning of a new age. Things are different than they were yesterday. The world is changing and we must adapt.” Yes, all very true statements but the new and “fool-proof” methods and strategies and overleveraging and excess risk-taking only work when the economic environmental conditions allow them to work. Using the latest “fool-proof” investment strategy is like running around a thunderstorm with a lightning rod in your hand: if you’re unharmed after a while then it might seem like you’ve developed a method to avoid getting struck by lightning – but sooner or later you will get hit. And yet value investors are for the most part immune to the thunder and lightning. This isn’t at all to say that value investors never lose money, go bust, or suffer during recessions. However, by sticking to fundamentals and avoiding excessive risk-taking (i.e. dumb decisions), the collective value investor class seems to have much fewer examples of the spectacular crash-and-burn cases that often are found with investors’ who employ different strategies. As a result, value investors have historically outperformed other types of investors over the long term. And there is plenty of empirical evidence to back this up. Check this and this and this and this out. In fact, since 1926 value stocks have outperformed growth stocks by an average of four percentage points annually, according to the authoritative index compiled by finance professors Eugene Fama of the University of Chicago and Kenneth French of Dartmouth College. So, the value investing philosophy has endured for over 80 years and is the most consistently successful strategy that can be applied. And while hot stocks, over-leveraged portfolios, and the newest complicated financial strategies will come and go, making many wishful investors rich very quick and poor even quicker, value investing will quietly continue to help its adherents fatten their wallets. It will always endure and will always remain classically in fashion. In other words, value investing is vintage. Which explains half of this website’s name. As for the value part? The intention of this site is to explain, discuss, ask, learn, teach, and debate those topics and questions that I’ve always been most interested in, and hopefully that you’re most curious about, too. This includes: What is value investing? Value investing strategies Stock picks Company reviews Basic financial concepts Investor profiles Investment ideas Current events Economics Behavioral finance And, ultimately, ways to become a better investor I want to note the importance of the way I use value here. It’s not the simplistic definition of “low P/E” stocks that some financial services lazily use to classify investors, which the word “value” has recently morphed into meaning. To me, value investing equates to the term “Intelligent Investing,” as described by Ben Graham. Intelligent investing involves analyzing a company’s fundamentals and can be characterized by an intense focus on a stock’s price, it’s intrinsic value, and the very important ratio between the two. This is value investing as the term was originally meant to be used decades ago, and is the only way it should be used today. So without much further ado, it’s my very good honor to meet you and you may call me…
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