As the notes of the 2015 Daily Journal Annual Meeting are released, we encounter some of Charlie Munger (Trades, Portfolio)'s answers to questions regarding valuation. As usual, his wisdom is notorious as he mentions how he applies multidisciplinarity, opportunity costs and several other factors to reach a discount rate:
Questioner: My question: As an investor, what do you use to value a business or a company? How do you use the discount rate to calculate intrinsic value?
Munger: Obviously, it’s relevant what the return you get on your bonds is; that affects the value of other assets in the general climate. Obviously, your opportunity costs should cover your own investment decision making. If you happen to have a rich uncle who will sell you his business for 10% of what it’s worth, you don’t want to think about some other investment. If the opportunity cost is so great, considering everything else, you should forget about it. And most people don’t pay enough attention to opportunity cost. Bridge players know about opportunity cost. Poker players know about opportunity cost. But in an MBA faculty members and other important people, they hardly know their ass from a plate of hot squash.
Questioner: When you try to arrive at a valuation number using the discount rate, does it mean that between the two rates …
Munger: We don’t use numeric formulas that way. We take into account a whole lot of factors. It’s a multi-factor thing. And there are tradeoffs between factors. It’s just like a bridge hand. You have to think of a lot of different things at once. There’s never going to be a formula that will make you rich just by going through some horrible process. If that were true, every mathematical nerd who gets A’s in algebra would be rich. So you have to be comfortable thinking about a lot of things at once, and correctly thinking about a lot of things at once. And we don’t have a formula that will help you. And all that stuff is relevant. Opportunity cost, of course, is crucial. And, of course, the risk-free rate is a factor.
Questioner: Do you use the same rate for different types of businesses?
Munger: No, of course not. Different businesses get different treatments. They all are viewed in terms of value, and they’re weighed one against another. But a person will pay more for a good business than for a lousy one. We really don’t want any lousy businesses anymore. We used to make money betting on reinventing lousy businesses and kind of wringing money out of them, but that is a really painful, difficult way to make money, especially if you’re already rich. We don’t do much of it anymore. Sometimes we do it by accident because one of our businesses turns lousy, and in that case it’s like dealing with your relatives you can’t get rid of. We deal with those as best we can, but we’re out looking for new ones.
So a quick summary of Munger's recommendations:
Treat different businesses differently. Provided that every business is different in terms of predictability, earnings and pricing power, they should be discounted at different rates. Munger's remarks on taking into account multiple factors is very important. Thinking about Porter's five forces, Greenwald's competitive forces' drivers, among others, are powerful mental models that could help us go through this process in a more efficient way.
The discount rate depends on the risk-free rate and opportunity costs, among other factors. The value of general assets will be driven by the risk-free rate, which, as Warren Buffett mentioned, "act like gravity to all asset prices." Also, it is important to consider opportunity costs, as even if we get an attractive upside with a 15% discount rate, if we know of another deal providing 25%, the option we should go for is pretty obvious.
These recommendations are simple and straightforward; however, they are powerful and carry a great deal of the freight to arrive at a good estimate of the discount rate.
What do you think?
