Key lessons
– Keep it simple!
– Focus on what you know and try to find out as much as possible to decrease your risk
– The discount rate highly depends on your opportunity cost
– Don’t forget to apply a margin of safety
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This week’s post is key to concluding our initial discussion about company valuation. In last week’s post, What can you really earn?, we introduced the concept of Owner Earnings and as mentioned, this is the first step of our valuation exercise. The next step is to use the Owner Earnings we calculated and discount it at a certain rate to end up with a final value, which would basically represent the intrinsic value of the company being analyzed. What is the intrinsic value of a firm is almost a philosophical question. According to Investopedia, it is defined as “the actual value of a company or an asset based on an underlying perception of its true value including all aspects of the business, in terms of both tangible and intangible factors. This value may or may not be the same as the current market value.” What we are trying to do by valuing a firm is to find out if the price the market is asking for is lower or higher than the intrinsic value we are calculating. If intrinsic value is lower than market value, then we simply let it go (and might reconsider at a later stage). There’s no point in paying more than what we believe an asset is worth. However, if the intrinsic value of a company is higher than its market value, there might be a mispricing opportunity and we might want to act on it. By the way, I’m only considering long positions here and no short selling. This concept of intrinsic value is one of the pillars of value investing. Even if you find the best company in the world, if you pay too much for it, you’re still not making a wise investment.
When applying a discount rate to the Owner Earnings, you will want to keep it as simple as possible. Many analysts are using a Discounted Cash Flow (DCF) model to come up with a valuation metric. The downside in using a DCF model is that you have to project and discount back the financials of the firm 5, 10 or even 20 years into the future and as it is proven that beyond approximately 18 months any kind of projection is basically pure imagination, it is very difficult to rely on these figures. Instead, what you want to make sure is that you truly understand the business you’re investing in and that it will keep going at least at today’s level, forever. You’ll notice that value investing relies enormously on qualitative factors as compared to quantitative factors. There’s a reason why Buffett doesn’t even have a calculator in his office, not to mention a computer (as we are not Warren Buffett, I would not necessarily recommend that approach though). The formula to calculate intrinsic value based on Owner Earnings is quite straight forward:
Intrinsic value = Owner Earnings / Discount rate
It might be simple, but it’s unfortunately not that easy to apply. The key question is how much should the discount rate be? The lower your discount rate, the higher (the more expensive) your intrinsic value will be as of today. Think of it this way, if your discount rate is 10% for example, then considering the Owner Earnings you’ve calculated, it would take you 10 years (100%/10%) to get your money back. At 5%, it’s 20 years, and so on.
As this discount rate is important to valuation, a lot of people have thought about it and there are a few theoretical concepts which are widely accepted. The most well-known formula is called Weighted Average Cost of Capital (WACC), without going into the detail, this formula depends on the company’s leverage ratio (over time), the cost of its debt, and the cost of its equity, which itself depends on the risk free rate, beta which is the sensitivity of the expected stock return to the market return, and the market rate of return… With so many moving pieces based on forecasts and best estimates, good luck in finding a reliable value! In theory, it might make sense, however it is practically impossible to find the “right” value – and you’ll lose time in the process. It also gives the analyst the wrong impression that by putting a lot of work in this formula, you will end up with precisely the correct answer, which is everything but true. To add to all this, this WACC formula is normally used in combination with a complex DCF model which in itself doesn’t make any sense.
So, if these theories can’t be relied on, how can we find out a value for the discount rate? Let’s first consider two quotes from Charlie Munger and Warren Buffett on the topic.
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.”
Buffett: “We don’t formally have a discount rate. We want a significantly higher return than from a government bond – that’s the yardstick, but not if government bond rates are 2-3%. It’s a little of wanting enough that we’re comfortable. It sounds fuzzy because it is. Charlie and I have never talked in terms of hurdle rates.”
The key words here are “opportunity cost”. The assumption is that you can always invest in (US) risk-free government bonds, which will offer a different yield depending on the period in time. There was a time when Buffett was simply using the 10-year US treasury rate as the discount rate. That’s because the treasury rate was so high that its opportunity cost could be directly compared to the expected return on equities. However, when the rates are as low as today, there’s no way investors would accept that kind of return on their equity investments. It’s important to also understand that Buffett/Munger don’t focus only on today’s risk-free rate but they know that treasury rates will fluctuate in the future. So, if your investment period is “forever”, you’d be mistaken to consider only today’s treasury rate.
Why is it then that when interest rates fall, the stock market goes up? Let’s take a look at three inter-connected factors. First, the stock market is very short-term oriented. Therefore, when investors and traders consider stock prices they rely on today’s risk-free rates and so if the rates go down, stock market participants are ready to pay more for the same stocks. Second, as interest rates go down, investors and traders hope for better returns on the stock market and so take money out of the government bonds (and even borrow) and put it to work on the stock market, which pushes prices up. Lastly, when money becomes cheap, it’s easier for firms to borrow and invest for the future, which in theory should push up earnings and therefore increases company valuations. It is also much cheaper for consumers to borrow and spend money. This money ends up in the pockets of companies, which has a positive impact on their financials. But remember, all of this is short-term focused. This is also why, when interest rates go up, it is usually easier to find good bargains.
Coming back to the concept of opportunity cost, it all depends on the investment opportunities you have available at a certain time. If you have plenty of choices offering a potential return of say 12%, why would you want to discount your Owner Earnings at a rate of 8%? You might want to set a certain hurdle rate, but I would suggest keeping a flexible approach in that sense, depending on the opportunities available. In general, a discount rate of about 9%-12% would most likely make sense.
That being said, these should be the only factors influencing the discount rate to select. Increasing the discount rate to adjust for risk can be very risky in itself. Instead, in order to decrease risk, you should have done all the necessary work to make sure you understand the company, its business and the industry it operates in.
Margin of safety
The margin of safety is the difference (in %) between the intrinsic value of a stock and its market price. As it’s impossible to calculate a precise valuation metric, you want to make sure you give it some room for error. Therefore, in general, I’d recommend a margin of safety of at least 30%. Which means that the intrinsic value you calculated needs to be at least 30% above the market price before considering to buy the stock.
What about growth?
As mentioned in my last post, the Owner Earnings calculation doesn’t include any growth, neither does the discount rate. As there is already ample room for error, the key to these calculations is to keep it as simple as possible and try to rely only on data that we know as of today. Using the methodology I’ve presented, if ever there is growth in the future, you basically get it “for free”. If you are confident enough and believe in strong growth, you might want to increase your Owner Earnings amount to reflect that growth. However, you want to be extremely careful in doing so and make sure you have done all the necessary background work.
That concludes our discussion on valuation! Hope you’ve enjoyed and let me know what you think and if you have any questions.
Keep growing your snowball!
Next post, next week!
