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Why it's wrong to play with discount rates

March 17, 2013
whopper investments

whopper investments

49 followers
Every now and then, I’ll do a post on different types of accounting or broad finance topics when I feel it’s helpful for readers or will help me with a potential post (for example, see this post on LIFO / FIFO). Today, I want to do a post on why you should not mess with discount rates when valuing companies. The reason behind this post will become apparent in a post I’m going to do next week.

Let me give a bit of background: I never do DCF valuations when investing. I generally try to get some form of asset cushion and buy in at a low price relative to normalized earnings. Many would argue that form of “multiples type” investing is a backhanded way of doing a DCF. Technically, they’re correct, but I’d rather use my way and be roughly right than use a DCF and be precisely wrong.

That said, I do have a lot of experience with DCF type valuation. And one of my pet peeves with DCF is when I see an author say “O, this is a small company, so let’s add 2% to the discount rate.”

Increasing a discount rate because of that is wrong. Every time. Doesn’t matter the reason. If you’re doing a DCF, apply the same discount rate to every company you value.

Why?

Let’s walk through an example to find out. Below is a quick DCF I did. It shows the value of a company that produces $100 in cash flows and grows that cash flow 2% per year forever. The only thing that changes is the discount rate.

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Look at that change in value! Simply changing the discount rate from 8% to 12 % cuts the NPV to an investor by 47%. Changing it from 8% to 16% cuts it by 57%.

Let’s step away from that for a second and consider a company that we’re investing in today that owns one asset: an insurance policy that will pay off if it rains tomorrow. If it rains tomorrow, the policy pays $1,700 (NPV = $1,700, the same as our company with the 8% discount rate). If it doesn’t rain tomorrow, the policy is worthless.

What does the chance of it raining need to be for the value of that policy to equal $1,020? Using the formula (chance of raining * $1,700) + ((1- chance of raining) * 0), we can figure out that we have to believe there’s a 60% chance of it raining for that lottery ticket to be worth $1,020. Taking the other sides, there has to be a 40% chance of failure for that lottery ticket to be worth $1,020. You can see that same 40% on my excel spreadsheet under the “value change (%)” line next to the 12% discount rate scenario.

Apply that scenario to the business. What we’ve effectively done when we’ve raised the discount rate from 8% to 12% is increased the chance of the business failing from 0% to 40%! Increase it from 8% to 16%, and you’ve said your company has a 57% of failing.

In other words, by increasing discount rate because of size, or industry, or management, or control, or whatever…. what you’ve effectively done is said the business has the same chance of failing as a start up bio-tech firm.

Now, many of you will argue that it’s not that simple. But it actually is that simple. Why should a cash flow be worth less because a company is small, or the business is cyclical? Answer: it shouldn’t.

If you want to be clearer in your discount rates and get better usage out of your DCF modeling, model the cash flows from multiple scenarios. Then assign a % chance to each of those scenarios and add up all of the present values. That will give you a stock value that you can compare to today’s stock price.

For example, if you’re modeling a mining company, don’t just do one DCF, bring it back at 15%, and buy the stock. Instead, do four models. Do one if production stays steady. Do one if capex way overruns targets. Do one if gold prices crash. And do one if gold prices go through the rough. Discount all of those back at the same discount rate (I use 10% for all of my discount rates, but feel free to use whatever you want). Now assign a % chance to each scenario happening (be sure the % add up to 100%!). Multiply the value of each scenario by the % chance of it happening, add them all up, and BAM! You’ve got yourself a target EV.

What are the advantages of this method? O man, there are tons. First, by playing around with different scenarios, you will force yourself to think about what could go wrong (or right) for the business and what effect that will have on cash flows. By using the same interest rate across companies, you’ll be able to compare the expected value of all of your investments to their current stock price and figure out what your most undervalued holdings are.

Perhaps most importantly, you’ll open up a new world of small cap stocks to yourself. As you can see from the “insurance policy” analysis, it’s tough for a stock to be attractive at a 12% discount rate if you use 8% for another- to buy that 12% stock over the 8% stock, you’re going to have either 1) get lucky and compare an incredible value to a true dog of a stock or 2) you’re going to have model an extremely optimistic assumption, which has the effect of turning your DCF into a “garbage in, garbage out” model. When you do an “optimistic model,” your DCF is no longer helping you to invest; it’s become an excuse to justify your investment.

But if you use the same rate across companies and compare chance of failure or downside scenarios, you’re going to find yourself attracted to a lot of new and interesting stocks. And I bet you’re going to find yourself growing and developing as an investor.

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