A key topic of Chang Jing's second lecture in Peking University's Fall 2020 Value Investing Course is the DCF (discounted cash flow) model and its shortcomings. Related to the discussion of DCF is the choice of discount rate. Below are my notes and thoughts on this topic.
Basic assumptions and shortcomings of DCF
When using DCF, we have to make some basic assumptions regarding the future cash flow, discount rate, time period, terminal value and growth rate. It is the theoretically correct approach to calculate intrinsic values. It is a scientific approach, again in theory. But it does have many shortcomings in practice. Very often DCF is not actually very helpful, in my experience.
The biggest shortcoming of the DCF approach is that we have to make many assumptions about the future. We can even say that because we have to make so many assumptions, our estimate of intrinsic value using the DCF approach is unreliable. For instance, how should we evaluate companies like Amazon (AMZN, Financial), which are still unprofitable on an accounting basis but generate decent cash flows? Is cash flow a good proxy to evaluate Amazon's true profitability in the future? We don't know what the future holds for Amazon. Today, Amazon very much looks entrenched. But ten years ago, it was very hard to foresee Amazon's dominant position.
This is not to say that we cannot predict the future under any circumstances. For some investors, for some businesses, under certain circumstances, over a certain period of time, predicting the future is doable, if unreliable.
Discount rate
Discount rate is a key assumption we have to make when using DCF models. We have a few choices for discount rate used in the DCF model. Among the choices are risk free interest rates, weighted average cost of capital, opportunity cost, required rate of return, inflation and internal rate of return. Which discount rate is appropriate and reasonable?
There are pros and cons of each choice. What matters is not which discount rate you choose, but what implications does it have if you choose a specific discount rate? For instance, you can use opportunity cost as your discount rate, which is your best alternative. You can also use the risk-free rate as your discount rate and add a risk premium when appropriate.
In the end, it boils down to what you are trying to accomplish. If your goal is to protect your purchasing power over time, maybe the inflation rate is good discount rate to use. If your goal is to compound at 15% a year, then 15% is the discount rate you should use, assuming you know what types of investment can yield a risk-adjusted return of 15% a year. It also depends on your cost of capital. There are many factors to consider.
In value investing, the risk-free rate of return is the most common discount rate to use. Note that this risk-free rate of return is different from the risk-free interest rate. The risk-free interest rate is the yield of government debts of different maturities. The risk-free rate of return is the return of stock indexes. It's applicable especially over the long run, as long as the economy can keep compounding sustainably. Since 1801, stocks indexes have compounded at about 6.7% a year, so perhaps 6.7% is a risk-free rate of return in the long run.
Again, there are big assumptions behind this risk-free rate of return. First of all, we have to assume the economy can continuously compound at a rate similar to the historical growth rate. This may not be true. Secondly, the 6.7% rate of return of stock indexes is over a really long period of time. Your holding period has to match the same time horizon. There are long stretches of periods when the returns from the stock market indexes are much lower than the historic average. There are periods in which the returns from the indexes are much higher than the historic average.
As Warren Buffett (Trades, Portfolio) once explained, during the 20th Century, the GDP per capita in the United States went up 610%. It went up every decade. However, the Dow Jones Industrial Index tells a different story. Basically, during the 20th Century, there were six big periods in there for the stock market in both directions. There were three big bull markets. The Dow moved from 66 to 10,000 during the century, but almost all the gains occurred during the three big bull markets of almost 44 years. For the remaining 56 years, net, the Dow was down a few hundred points.
During the first two decades, the Dow didn't move. From 1965 to 1981, the Dow actually went down and from 1929 to 1948, the Dow was cut in half. Most investors would consider two decades as long term.
Now let's consider this question, should an investor use 6.7% as the risk-free rate of return for the next twenty years? If so, what implications does it have? If not, why not?
As Chang emphasized, it's not which discount rate you choose that matters, it's the logic and reasoning and the implications behind your choices that matter. You have to know what assumptions have been made and what goals you are trying to accomplish.
Read more here:
- Notes From Peking University's Fall 2020 Value Investing Course - Yutong Bus Case Study
- Notes From Peking University's Fall 2020 Value Investing Course - Lecture 2​
- 3 Criteria of Assessing Competency
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