Seth Klarman, in his book, “Margin of Safety: Risk-Averse Value Investing Strategies for the Thoughtful Investor,” addressed some characteristics associated with the Net Present Value (or NPV) approach to valuation. In this article, I would like to share some of Mr. Klarman’s thoughts on Net Present Value.
The Net Present Value method of valuation is performed by discounting future cash flows at an appropriate rate (or rates) to obtain an equivalent present value of those cash flows. Essentially, you are just trying to move future cash flows back to the present time and determine how much those cash flows are worth today.
While NPV sounds easy, it is far from it. There are two parts to any NPV analysis: 1) determining future cash flows, and 2) determining an appropriate discount rate or rates. The process of estimating future cash flows can be very difficult; and the choice of using one or more discount rates can be highly subjective. Both future cash flows and discount rate(s) can depend on a large number of factors.
While Net Present Value can produce a wide range of present value estimates, it is nevertheless one of the key valuation methods available to investors – and thus, it should be thoughtfully considered in any business valuation.
With that background in place, I would like to present some of Seth Klarman’s thoughts on “present-value analysis and the difficulty of forecasting future cash flow.” After that, I will present some quotes from “Margin of Safety” about choosing an appropriate discount rate. (Note: Interspersed throughout these quotes are a few of my own thoughts and comments.)
Present-Value Analysis and the Difficulty of Forecasting Future Cash Flow
1)“An unresolvable contradiction exists: to perform present value analysis, you must predict the future, yet the future is not reliably predictable.” (Margin of Safety, pg. 124)
2) “When future cash flows' are reasonably predictable and an appropriate discount rate can be chosen, NPV analysis is one of the most accurate and precise methods of valuation. Unfortunately future cash flows are usually uncertain, often highly so. Moreover, the choice of a discount rate can be somewhat arbitrary. These factors together typically make present value analysis an imprecise and difficult task.” (Margin of Safety, pg. 122)
3) “Although some businesses are more stable than others and therefore more predictable, estimating future cash flow for a business is usually a guessing game. A recurring theme in this book is that the future is not predictable, except within fairly wide boundaries. Will Coca-Cola sell soda next year? Of course. Will it sell more than this year? Pretty definitely, since it has done so every year since 1980. How much more is not so clear. How much the company will earn from selling it is even less clear; factors such as pricing, the sensitivity of demand to changes in price, competitors' actions, and changes in corporate tax rates all may affect profitability. Forecasting sales or profits many years into the future is considerably more imprecise, and a great many factors can derail any business forecast.” (Margin of Safety, pg. 123)
4) Mr. Klarman addresses the difficulty of predicting earnings growth as follows: “…while investors tend to oversimplify growth into a single number, growth is, in fact, comprised of numerous moving parts which vary in their predictability. For any particular business, for example, earnings growth can stem from increased unit sales related to predictable increases in the general population, to increased usage of a product by consumers, to increased market share, to greater penetration of a product into the population, or to price increases. Specifically, a brewer might expect to sell more beer as the drinking-age population grows but would aspire to selling more beer per capita as well. Budweiser would hope to increase market share relative to Miller. The brewing industry might wish to convert whiskey drinkers into beer drinkers or reach the abstemious segment of the population with a brand of nonalcoholic beer. Over time companies would seek to increase price to the extent that it would be expected to result in increased profits….Some of these sources of earnings growth are more predictable than others. Growth tied to population increases is considerably more certain than growth stemming from changes in consumer behavior, such as the conversion of whiskey drinkers to beer. The reaction of customers to price increases is always uncertain. On the whole it is far easier to identify the possible sources of growth for a business than to forecast how much growth will actually materialize and how it will affect profits.” (Margin of Safety, pg. 124)
5) “How do value investors deal with the analytical necessity to predict the unpredictable? The only answer is conservatism. Since all projections are subject to error, optimistic ones tend to place investors on a precarious limb. Virtually everything must go right, or losses may be sustained. Conservative forecasts can be more easily met or even exceeded. Investors are well advised to make only conservative projections and then invest only at a substantial discount from the valuations derived therefrom.” (Margin of Safety, pg. 125) (Note: Bold added for emphasis. I believe that conservatism is the key of any successful investment plan.)
The Choice of a Discount Rate
1) “The other component of present-value analysis, choosing a discount rate, is rarely given sufficient consideration by investors. A discount rate is, in effect, the rate of interest that would make an investor indifferent between present and future dollars.” (Margin of Safety, pg. 125-126)
2) “There is no single correct discount rate for a set of future cash flows and no precise way to choose one. The appropriate discount rate for a particular investment depends not only on an investor's preference for present over future consumption but also on his or her own risk profile, on the perceived risk of the investment under consideration, and on the returns available from alternative investments.” (Margin of Safety, pg. 126)
3) “The underlying risk of an investment's future cash flows must be considered in choosing the appropriate discount rate for that investment. A short-term, risk-free investment (if one exists) should be discounted at the yield available on short-term U.S. Treasury securities, which, as stated earlier, are considered a proxy for the risk-free interest rate. Low-grade bonds, by contrast, are discounted by the market at rates of 12 to 15 percent or more, reflecting investors' uncertainty that the contractual cash flows will be paid.” (Margin of Safety, pg. 126) (Note: “Margin of Safety” was published in 1991; and so, the low-grade bond rates quoted by Seth Klarman are most likely from that time period.)
4) “It is essential that investors choose discount rates as conservatively as they forecast future cash flows. Depending on the timing and magnitude of the cash flows, even modest differences in the discount rate can have a considerable impact on the present-value calculation.” (Margin of Safety, pg. 126)
5) “How can investors know the "correct" level of interest rates in choosing a discount rate? I believe there is no ‘correct’ level of rates. They are what the market says they are, and no one can predict where they are headed. Mostly I give current, risk-free interest rates the benefit of the doubt and assume that they are correct.” (Margin of Safety, pg. 127)
6) “At times when interest rates are unusually low, however, investors are likely to find very high multiples being applied to share prices. Investors who pay these high multiples are dependent on interest rates remaining low, but no one can be certain that they will. This means that when interest rates are unusually low, investors should be particularly reluctant to commit capital to long-term holdings unless outstanding opportunities become available, with a preference for either holding cash or investing in short-term holdings that quickly return cash for possible redeployment when available returns are more attractive.” (Margin of Safety, pg. 127) (Note: Given the currently low interest rate environment, we would all be wise to read and really think about this quote.)
7) “Investors can apply present-value analysis in one of two ways. They can calculate the present-value of a business and use it to place a value on its securities. Alternatively, they can calculate the present-value of the cash flows that security holders will receive: interest and principal payments in the case of bondholders and dividends and estimated future share prices in the case of stockholders….Calculating the present value of contractual interest and principal payments is the best way to value a bond. Analysis of the underlying business can then help to establish the probability that those cash flows will be received. By contrast, analyzing the cash flows of the underlying business is the best way to value a stock.” (Margin of Safety, pg. 127-128)
8) “Once future cash flows are forecast conservatively and an appropriate discount rate is chosen, present value can be calculated. In theory, investors might assign different probabilities to numerous cash flow scenarios, then calculate the expected value of an investment, multiplying the probability of each scenario by its respective present value and then summing these numbers. In practice, given the extreme difficulty of assigning probabilities to numerous forecasts, investors make do with only a few likely scenarios. They must then perform sensitivity analysis in which they evaluate the effect of different cash flow forecasts and different discount rates on present value. If modest changes in assumptions cause a substantial change in net present value, investors would be prudent to exercise caution in employing this method of valuation.” (Margin of Safety, pg. 128)
I hope Mr. Klarman’s words regarding Net Present Value have been helpful to you.
Remember to be conservative in your estimates of future cash flows and discount rates, and to perform sensitivity analysis. Hopefully, by following these few common-sense steps/reminders, we will make better use of NPV analysis and become better investors.
The Net Present Value method of valuation is performed by discounting future cash flows at an appropriate rate (or rates) to obtain an equivalent present value of those cash flows. Essentially, you are just trying to move future cash flows back to the present time and determine how much those cash flows are worth today.
While NPV sounds easy, it is far from it. There are two parts to any NPV analysis: 1) determining future cash flows, and 2) determining an appropriate discount rate or rates. The process of estimating future cash flows can be very difficult; and the choice of using one or more discount rates can be highly subjective. Both future cash flows and discount rate(s) can depend on a large number of factors.
While Net Present Value can produce a wide range of present value estimates, it is nevertheless one of the key valuation methods available to investors – and thus, it should be thoughtfully considered in any business valuation.
With that background in place, I would like to present some of Seth Klarman’s thoughts on “present-value analysis and the difficulty of forecasting future cash flow.” After that, I will present some quotes from “Margin of Safety” about choosing an appropriate discount rate. (Note: Interspersed throughout these quotes are a few of my own thoughts and comments.)
Present-Value Analysis and the Difficulty of Forecasting Future Cash Flow
1)“An unresolvable contradiction exists: to perform present value analysis, you must predict the future, yet the future is not reliably predictable.” (Margin of Safety, pg. 124)
2) “When future cash flows' are reasonably predictable and an appropriate discount rate can be chosen, NPV analysis is one of the most accurate and precise methods of valuation. Unfortunately future cash flows are usually uncertain, often highly so. Moreover, the choice of a discount rate can be somewhat arbitrary. These factors together typically make present value analysis an imprecise and difficult task.” (Margin of Safety, pg. 122)
3) “Although some businesses are more stable than others and therefore more predictable, estimating future cash flow for a business is usually a guessing game. A recurring theme in this book is that the future is not predictable, except within fairly wide boundaries. Will Coca-Cola sell soda next year? Of course. Will it sell more than this year? Pretty definitely, since it has done so every year since 1980. How much more is not so clear. How much the company will earn from selling it is even less clear; factors such as pricing, the sensitivity of demand to changes in price, competitors' actions, and changes in corporate tax rates all may affect profitability. Forecasting sales or profits many years into the future is considerably more imprecise, and a great many factors can derail any business forecast.” (Margin of Safety, pg. 123)
4) Mr. Klarman addresses the difficulty of predicting earnings growth as follows: “…while investors tend to oversimplify growth into a single number, growth is, in fact, comprised of numerous moving parts which vary in their predictability. For any particular business, for example, earnings growth can stem from increased unit sales related to predictable increases in the general population, to increased usage of a product by consumers, to increased market share, to greater penetration of a product into the population, or to price increases. Specifically, a brewer might expect to sell more beer as the drinking-age population grows but would aspire to selling more beer per capita as well. Budweiser would hope to increase market share relative to Miller. The brewing industry might wish to convert whiskey drinkers into beer drinkers or reach the abstemious segment of the population with a brand of nonalcoholic beer. Over time companies would seek to increase price to the extent that it would be expected to result in increased profits….Some of these sources of earnings growth are more predictable than others. Growth tied to population increases is considerably more certain than growth stemming from changes in consumer behavior, such as the conversion of whiskey drinkers to beer. The reaction of customers to price increases is always uncertain. On the whole it is far easier to identify the possible sources of growth for a business than to forecast how much growth will actually materialize and how it will affect profits.” (Margin of Safety, pg. 124)
5) “How do value investors deal with the analytical necessity to predict the unpredictable? The only answer is conservatism. Since all projections are subject to error, optimistic ones tend to place investors on a precarious limb. Virtually everything must go right, or losses may be sustained. Conservative forecasts can be more easily met or even exceeded. Investors are well advised to make only conservative projections and then invest only at a substantial discount from the valuations derived therefrom.” (Margin of Safety, pg. 125) (Note: Bold added for emphasis. I believe that conservatism is the key of any successful investment plan.)
The Choice of a Discount Rate
1) “The other component of present-value analysis, choosing a discount rate, is rarely given sufficient consideration by investors. A discount rate is, in effect, the rate of interest that would make an investor indifferent between present and future dollars.” (Margin of Safety, pg. 125-126)
2) “There is no single correct discount rate for a set of future cash flows and no precise way to choose one. The appropriate discount rate for a particular investment depends not only on an investor's preference for present over future consumption but also on his or her own risk profile, on the perceived risk of the investment under consideration, and on the returns available from alternative investments.” (Margin of Safety, pg. 126)
3) “The underlying risk of an investment's future cash flows must be considered in choosing the appropriate discount rate for that investment. A short-term, risk-free investment (if one exists) should be discounted at the yield available on short-term U.S. Treasury securities, which, as stated earlier, are considered a proxy for the risk-free interest rate. Low-grade bonds, by contrast, are discounted by the market at rates of 12 to 15 percent or more, reflecting investors' uncertainty that the contractual cash flows will be paid.” (Margin of Safety, pg. 126) (Note: “Margin of Safety” was published in 1991; and so, the low-grade bond rates quoted by Seth Klarman are most likely from that time period.)
4) “It is essential that investors choose discount rates as conservatively as they forecast future cash flows. Depending on the timing and magnitude of the cash flows, even modest differences in the discount rate can have a considerable impact on the present-value calculation.” (Margin of Safety, pg. 126)
5) “How can investors know the "correct" level of interest rates in choosing a discount rate? I believe there is no ‘correct’ level of rates. They are what the market says they are, and no one can predict where they are headed. Mostly I give current, risk-free interest rates the benefit of the doubt and assume that they are correct.” (Margin of Safety, pg. 127)
6) “At times when interest rates are unusually low, however, investors are likely to find very high multiples being applied to share prices. Investors who pay these high multiples are dependent on interest rates remaining low, but no one can be certain that they will. This means that when interest rates are unusually low, investors should be particularly reluctant to commit capital to long-term holdings unless outstanding opportunities become available, with a preference for either holding cash or investing in short-term holdings that quickly return cash for possible redeployment when available returns are more attractive.” (Margin of Safety, pg. 127) (Note: Given the currently low interest rate environment, we would all be wise to read and really think about this quote.)
7) “Investors can apply present-value analysis in one of two ways. They can calculate the present-value of a business and use it to place a value on its securities. Alternatively, they can calculate the present-value of the cash flows that security holders will receive: interest and principal payments in the case of bondholders and dividends and estimated future share prices in the case of stockholders….Calculating the present value of contractual interest and principal payments is the best way to value a bond. Analysis of the underlying business can then help to establish the probability that those cash flows will be received. By contrast, analyzing the cash flows of the underlying business is the best way to value a stock.” (Margin of Safety, pg. 127-128)
8) “Once future cash flows are forecast conservatively and an appropriate discount rate is chosen, present value can be calculated. In theory, investors might assign different probabilities to numerous cash flow scenarios, then calculate the expected value of an investment, multiplying the probability of each scenario by its respective present value and then summing these numbers. In practice, given the extreme difficulty of assigning probabilities to numerous forecasts, investors make do with only a few likely scenarios. They must then perform sensitivity analysis in which they evaluate the effect of different cash flow forecasts and different discount rates on present value. If modest changes in assumptions cause a substantial change in net present value, investors would be prudent to exercise caution in employing this method of valuation.” (Margin of Safety, pg. 128)
I hope Mr. Klarman’s words regarding Net Present Value have been helpful to you.
Remember to be conservative in your estimates of future cash flows and discount rates, and to perform sensitivity analysis. Hopefully, by following these few common-sense steps/reminders, we will make better use of NPV analysis and become better investors.
