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Rupert Hargreaves
Rupert Hargreaves
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Warren Buffett's 3% Discount Rate Margin

At look at one strategy Warren Buffett uses to place a value on businesses

October 16, 2020 | About:

Business valuation is an art, not a science, because the worth of a business is hugely dependant on who is doing the valuing.

There are many different ways to value a company. Some investors might prefer a discount cash flow analysis. Others might prefer discounting dividends. There's no correct method. The style can also vary from business to business.

To give one example, financial companies are easier to value using metrics like book value and dividend growth because their cash flow figures are so challenging to break down. It's far easier to look at book value as well.

Warren Buffett and valuation

Warren Buffett (Trades, Portfolio) has been perfecting his valuation techniques for the last seven decades. During this time, he's seen several developments in the business environment that have almost certainly changed his strategy.

When he started investing, it was easy to find companies trading at deep discounts to the value of their assets. That began to change in the 1970s. Intangible assets began to play more of a role, and Buffett adjusted accordingly. He moved into investments like Coca-Cola (NYSE:KO) and The Washington Post (NYSE:GHC) that had valuable intangible assets.

Over the past decade, it has become harder to find unloved gems, so Buffett has moved into a different position. He's put Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) in the role of being a lender of last resort. Since 2008, we've seen Berkshire make some huge deals based on debt and preferred shares, which provide a guaranteed return (although Buffett has also continued to pick stocks).

Although his strategy has shifted over the years, Buffett's overriding aim has always been to buy investments at a discount to his intrinsic value estimate. The goal of this is to generate an acceptable return on investment.

In the late 1950s and 1960s, Buffett used book value to establish the intrinsic value of a business. He's since shifted to using more of a discounted cash flow model. These models rely on two critical numbers: the growth rate and the discount rate. Minute changes in either can produce considerable variations in outcomes.

On multiple occasions, Buffett has declared that he likes to find companies where he can estimate its future growth rate with a high degree of certainty. He'd rather assume Coca-Cola's income will grow at 1% above inflation, and be sure of that, then guess a high-growth tech stock will continue to grow at 20% per annum.

The discount rate

On the topic of the discount rate, Buffett has been rather more conservative. He's rarely stated what discount rate he is looking for. At the 1994 Berkshire annual meeting of shareholders, he gave the audience some idea. Speaking to an investor who asked about his valuation process, Buffett replied:

"I would say that in a world of 7% long-term bond rates that we would certainly want to think we were discounting future after-tax streams of cash at least a 10% rate. But that will depend on the certainty we feel about the business. The more certain we feel about a business, the closer we are willing to play it."

This suggests Buffett was seeking a 3% margin on a highly certain business. Coca-Cola might fall into this bucket. Today, the 30-year Treasury rate is 1.53%, with the rate on the 10-year sitting at 0.74%. Add a 3% margin to these, and you get a prospective discount rate of 4.53% to 3.74%.

These rates are relatively low, but they reflect the current environment. It should also be pointed out that these are based on what Buffett once called "inevitables," companies that have seemingly inevitable growth rates. These are few and far between. It's likely that for most businesses, the discount rate would be much higher.

Disclosure: The author owns shares in Berkshire Hathaway.

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About the author:

Rupert Hargreaves
Rupert is a committed value investor and regularly writes and invests following the principles set out by Benjamin Graham. He is the editor and co-owner of Hidden Value Stocks, a quarterly investment newsletter aimed at institutional investors.

Rupert holds qualifications from the Chartered Institute for Securities & Investment and the CFA Society of the UK. He covers everything value investing for ValueWalk and other sites on a freelance basis.

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