The Proper Discount Rate

9 04 2010

Once you understand the discounted cash flow models, valuing a business is pretty straight-forward (but not necessarily easy). The only factor that is seemingly subjective is the discount rate. When a 5% discount rate gives a value about 4 times higher than a 15% discount rate, you know that selecting the correct rate is highly important. But what is the correct rate? Let’s look at a few different perspectives on the issue.

Of course, I’ll start with good ole Mr. Buffett:

“Don’t worry about risk the way it is taught at Wharton. Risk is a go/no go signal for us—if it has risk, we just don’t go ahead. We don’t discount the future cash flows a 9% or 10%; we use the U.S. treasury rate. We try to deal with things about which we are quite certain. You can’t compensate for risk by using a high discount rate.”

Basically, Buffett uses the risk free rate to see what the company would be worth if the investment carried no possibility of loss. To compensate for the risk, he uses a margin of safety between his valuation and the current market price. When Buffett says that “you can’t compensate for risk by using a high discount rate,” he doesn’t mean it’s physically impossible to do. Rather, he means that it’s much easier to see and understand the difference between the intrinsic value and market price by looking at the margin of safety instead of the difference in discount rates. However, If Buffett was merely using the margin of safety to compensate for risk, he would not produce a return above the risk free rate. Buffett must also be using the margin of safety to create a higher than risk free rate of return (and a higher than market rate of return too!).

There are also other issues that I have with using the risk free rate. What happens when the treasury rate becomes ridiculously low? The 30 year treasury rate reached 4% again recently. Using that as a discount rate, one would see Johnson and Johnson to be at a 73% discount from its intrinsic value. Obviously that’s ridiculous. Now, you’re stuck guessing what margin of safety would actually supply you with a decent return. Turns out, Buffett has addressed this concern:

“For our discount rate, we basically think in terms of the long-term government rate. We don’t think we’re any good at predicting interest rates. But in times of what seem like very low rates, we might use a little higher rate.”

This seems like the most logical position to take on the issue. Take note that when the risk free interest rate rises above you’re discount rate, your intrinsic value becomes less.

How about Joe Ponzio of http://www.fwallstreet.com?

“Personally, I use 15% [discount rate] and require a 25% margin of safety on large, stable companies and a 50% margin of safety on less-than-sure companies.”

“Why did I use 15%? That is the minimum return I expect when I buy a stock.”

This is another logical position to take. The main difference between this strategy and Buffett’s strategy is that Joe has essentially placed his desired return into the discount rate instead of the margin of safety. Joe is using the margin of safety mostly for risk, not return whereas Buffett is using it for both risk and return.

Which method is the correct one? I don’t think there is necessarily a correct method. It’s a matter of preference. I doubt either Buffett or Joe would miss an opportunity because of their rates. Buffett uses a lower rate and a higher margin of safety. Joe uses a higher rate and a lower margin of safety. The real message to take away from this post is to NOT use the long-term treasury rate no matter what it is. People have interpreted Buffett’s first quote as a ticket to use the long-term treasury rate when it is very low. That is a recipe for disaster.

For our discount rate, we basically think in terms of the long-term government rate. We don’t think we’re any good at predicting interest rates. But in times of what seem like very low rates, we might use a little higher rate.

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