Warren Buffett on Discount Rates: Stick With What you Know

In a previous article on Warren Buffett (Trades, Portfolio), I covered some comments the Oracle of Omaha made in the past about the discount rate he used to calculate the intrinsic value of a company's cash flow.

In the article, I noted that Buffett liked to focus on companies where he believes cash flow is predictable. That way, it is easier for him to project future cash flows as there is less uncertainty about whether or not a business will earn a certain level of cash going forward.

I wanted to dig into this subject a bit more and explore what specifically Buffett is looking for in a predictable investment and how it influences his value assessment.

Buffett on discount rates

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The CEO of Berkshire Hathaway (NYSE:BRK.A) (NYSE:BRK.B) gave us some more insight into his strategy at Berkshire investors' 1994 annual meeting. He compared two different businesses, a water company, "which is going to be around for 100 years," and a high tech company.

Buffett noted that the cash produced by these two businesses is no different. Cash is cash. However, it would be harder to estimate a high growth tech company's cash flow in the future than the water company. He went on to add:

"And you may, therefore, want a bigger discount when you get all through with the calculation. But up to the point where you decide what you're willing to pay — you may decide you can't estimate it at all. I mean, that's what happens with us with most companies."

Many analysts believe it is appropriate to use a higher discount rate to analyze growth businesses. For example, some analysts might demand a 10% discount rate on small-cap growth stocks but just a 3% discount rate for high-quality blue-chip stocks.

In 1994, Buffett explained that this approach did not make much sense to him. In fact, he thought that it was "playing games with numbers" because if you don't understand a business in the first place, increasing the discount rate won't make up for this lack of understanding. As the Oracle of Omaha stated:

"So, we want to stick with businesses we think we understand quite well, and not try to have the whole panoply with all different kinds of risk rates, because, frankly, we think that'd just be playing games with numbers. I mean, we — I don't think you can stick something — numbers on a highly speculative business, where the whole industry's going to change in five years, and have it mean anything when you get through. If you say I'm going to stick an extra 6% in on the interest rate to allow for the fact — I tend to think that's kind of nonsense. I mean, it may look mathematical. But it's mathematical gibberish in my view."

Instead, he noted, investors should stick with businesses they can understand and use the government bond rate, rather than playing around with different figures to try and make a company they don't understand look cheap.

Based on current Treasury yields, Buffett's framework suggests investors should be using a prospective discount rate of 4.53% to 3.74%. This low discount rate does not leave much room for error. Nevertheless, it seems appropriate for predictable businesses in the blue-chip space in the current interest rate environment.

However, when used with the wrong business, this low discount rate could produce a far too optimistic valuation, which could lead to losses in the long term.

Unfortunately, blue-chip companies that look cheap based on this discount rate are few and far between. That's why it's sensible to load up when they appear and make the most of the opportunity.

Disclosure: The author owns shares in Berkshire Hathaway.

Read more here:

• Warren Buffett: Finding a Good Business Is More Important Than the Price
• Warren Buffett's 3% Discount Rate Margin
• Howard Marks: Prospective Returns Are About 'The Lowest They've Ever Been'

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