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Value Investing: Determining Your Discount Rate

Value investor with a deep passion for understanding and a desire to improve results over time.

How to determine the discount rate when doing DCF analysis of a stock

How to determine the discount rate when doing DCF analysis of a stock

Discounted Cash Flow

If you're already familiar with the discounted cash flow method of stock valuation, you recall that there are three components of any DCF analysis: the amount of expected free cash flows all added up for all time, discounted back to what the cash is worth today, with a terminal value added at the end.

For two of these three variables, there's a pretty straightforward method for determining what numbers to use: with the cash flows, investors will often simply use analysts' estimates (although there are other valid ways of estimating your own); with the terminal value, you can use price multiples, liquidation value, or going concern terminal value. However, the discount rate presents its own set of unique challenges, and there's not really one clear method you absolutely have to gravitate to.

Clearly, money in the future is worth less than money today, and this is due to both inflation and opportunities you're giving up by not putting the money elsewhere. Equally clearly, different successful value investors use different methods to calculate their discount rates. Because of this, you shouldn't feel obligated to pick one just because your favorite superinvestor uses said method.

My intention here is to present you with three different options you can use to determine your discount rate and a few other things to think about within each of the ways of calculating, so you can identify which of the methods will work best for you personally.

Method 1: The Risk-Free Rate

As a value investor, "opportunity cost" should be among your favorite words. After all, if your portfolio is fully invested (you don't currently have any leftover cash to invest), then you'll have to sell something in order to pick something new up.

This means that one of the first things you think about when determining the discount rate to use is whether you already have a better opportunity within your current investments. Even if your portfolio isn't fully invested, this is still a very good first step since putting new money to work on new investments only makes sense if the new investment is a better deal than the existing ones.

There's a notable caveat here, though: diversification. If your goal is to have a diversified portfolio, you may want to avoid being too concentrated in any one position, so it might make sense to buy something else. Still, you should take a peek at your current investments and ask whether you should just buy more of them instead of whatever the new hot thing is.

Similarly, the 10-year treasury yield is often used as a risk-free rate and a good proxy for a discount rate for lots of investors. The idea is simple: if you can get a 5% return from very low-risk bonds, why on earth would you accept anything lower than this from a stock you want to buy, given that you'd be taking on considerably more risk by buying the stock?

This means that investors demand what's called a risk premium, a return above and beyond the risk-free rate, in order to buy anything other than Treasuries. Because of this, many investors will use a discount rate that is a few points higher than the 10-year yield.

Similarly, others will examine their more conservative investments inside of their own portfolio and use that as their discount rate. Either way, taking a look at other opportunities out there is a great way to determine your own discount rate.

Method 2: WACC

This might sound kind of odd, but it costs businesses money to get . . . well, money. "Money costs money" might seem a bit tautological, but the general idea is simple: businesses typically raise capital by issuing shares (selling equity) or by borrowing money (going into debt).

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It may be useful to think of cash as fuel for the business, and the business has to "fill up" on cash from time to time in order to continue to grow at a good rate. Because of this, the cost of capital is a crucial factor in determining how profitable a business will be in the future. Jimmy from Learn to Invest breaks this concept down very well in the video below.

Clearly, paying back debt at a high interest rate can be prohibitive for a business, and so can selling equity. If you own a share worth 10% in a company, and the company issues another 10 shares, your share is now worth 5%. The company itself owns shares too, and the opposite of issuing shares is buying them back, or buybacks.

Buybacks are good for investors if the shares are bought at a good price since your shares become worth more when the company buys shares back, but remember, it's your money they're using for the buybacks, so you want them buying them at a good price.

WACC takes both the equity and debt into consideration, and using WACC for a discount rate implies that how much you'll make in the future depends on how much it costs the company to get money. While I agree that it's important to consider these factors, I don't personally use WACC in my own DCF analyses, and instead prefer to use opportunity cost while considering the company's cost of money, but there are loads of successful investors out there using this method.

Method 3: Flat Rate

The simplest method of determining your discount rate is to use a flat rate. One obvious downside here is that you don't modify the number you're looking for based on what money costs (as WACC addresses so well). A flat rate can be really similar to a risk-free rate, especially if you assume the risk-free rate doesn't change much over time; however, this can be a dangerous assumption to make since . . .

  1. Treasury yields can and do change materially, often quickly, and
  2. The return you expect from your existing portfolio's more conservative holdings can change rapidly

If constantly adjusting your discount rate isn't something you're interested in, the flat rate might be a better fit for you. Warren Buffett has suggested using what he calls a "ten cap," where you multiply "owner's earnings" by 10, and if the price of your investment is higher than that number, you simply say "no."

This implies that it takes 10 years for you to get your initial investment back, and Buffett suggests that this is a sensible investment. This ultra-simple example uses a 10% discount rate, and although Buffett's owner's earnings aren't exactly free cash flow, you can absolutely use a multiple like 10 to discount future flows.

Discounting Is the Important Thing

On balance, it doesn't matter so much which of the above methods you use to discount the value of future cash back to what it's worth today. The important thing is that you're using a discount rate at all, and keeping in mind that a bird in the hand is worth two in the bush.

Cash today is worth more than cash tomorrow, and your job is to determine by how much. By taking a look at other opportunities you have, considering how much it costs a company to get new money for investments, you can come up with a good rate for you to use.

Your rate may well be different than mine if you're expecting a different return from other investment opportunities, and you should certainly consider this whenever you use a DCF-type analysis. Whether you think WACC is wack or a flat rate is overly simplistic is entirely up to you.

This article is accurate and true to the best of the author’s knowledge. Content is for informational or entertainment purposes only and does not substitute for personal counsel or professional advice in business, financial, legal, or technical matters.

© 2022 Andrew Smith

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