What's the Proper Discount Rate to Use for a DCF Model?

Textbook theory says calculating discount rate should be done using the WACC, but that approach is flawed

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Aug 17, 2016
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For more than half a decade we’ve been managing money and writing articles as we’ve always done. My discounted cash flow model's a bit different than most.

If you’ve ever taken a finance class you’ve learned that you use a company’s weighted average cost of capital (WACC) as the discount rate when building a discounted cash flow (DCF) model. However, we almost always do away with making a company-specific estimate and use a consistent discount rate for all the companies we value.

To illustrate why let’s look at the consumer staples sector –Â Coca-Cola (KO, Financial) specifically. We recently wrote an article about why the consumer staples sector is overvalued so we will continue that theme by using Coca-Cola as an example to show some flaws in the textbook method for calculating a company’s WACC.

Brief refresher on WACC

First let’s take a brief refresher course on calculating a company’s cost of capital. The formula for WACC is a company’s percentage equity financing times cost of equity plus percentage debt financing times cost of debt times one minus the company's tax rate (interest is tax deductible). The formula is usually written as: WACC = E/V*Re + D/V*Rd * ( 1 – Tc)

  • E/V = percent equity financing.
  • Re = cost of equity.
  • D/V = percent debt financing.
  • Rd = cost of debt.
  • Tc = corporate tax rate.

Calculating a company’s percentage of debt and equity financing is pretty easy. Just take the company’s current market cap and add the book value of the company’s long-term debt from its latest financial statements. Likewise, calculating the cost of debt is fairly straightforward as well. Take the company's interest expense from its latest 10-K and divide it by the average of this year and last year’s long-term debt levels (yes, this will include some interest expense for short-term debt, but it is close enough for our purposes).

Calculating the cost of equity is usually done using the Capital Asset Pricing Model or CAPM. The formula for the cost of equity is the risk-free rate of return plus the stock price’s beta times the market rate of return (minus the risk-free rate of return). Typically the 10-year Treasury bond (trading at 1.55% as of this writing) is used as the risk-free rate of return and the market rate of return is usually the long-term average annual return for the stock market. Depending on the time series and market index you chose, you will usually get around 9% – Â up to 12% –Â as the market rate of return. I prefer to use 10% as it’s roughly in the middle of the various long-term market averages.

Looking at Coca-Cola as an example

Let’s go through valuing Coca-Cola using a traditional DCF model. Coke has a market cap of $192.08 billion and total long-term debt of $31.08 billion yielding an enterprise value of $223.16 billion. Long-term debt for the previous year, fiscal year 2014, was $22.59 billion. Interest expense for fiscal year 2015 was $856 million. The company had a tax rate of 23.3% for its latest fiscal year. Google Finance gives Coke’s beta as 0.51. As stated earlier we’ll use 10% as our market rate of return and the 10-year Treasury bond yield of 1.55% as our risk-free rate of return.

Coke’s cost of equity is 1.55% + beta of 0.51 * (10% - 1.55%) or 5.86%.

Coke’s cost of debt is $856 million/($31.08 billion + $22.59 billion)/2 or 3.19%.

Coke’s WACC is 86.1% * 5.86% + 13.9% * 3.19% * (1-23.3%) or 5.39%.

We can build a two-stage DCF model to see what kind of free cash flow growth rate Coke’s current stock price would imply. In our model we used a 10-year short-term growth period followed by a 3% perpetual growth rate. We added in Coke’s cash and short-term investments, subtracted long-term debt and added the book value of equity investments. We calculated the trailing 12 months free cash flow after making adjustments for working capital changes.

02May2017154230.jpg

The model shows that Coke would need to “grow” at just -2.5% per year for the next 10 years to justify its current stock price.

Now let’s look what happens when we use a discount rate of 10%. We will keep everything else the same.

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We get a growth rate of 11.2% needed to justify the stock price!

We can see just how much of a difference changes to the discount rate make in the model. If we use the textbook definition of a discount rate, we are subjecting our model to a huge amount of influence from current interest rates and the stocks beta.

Which discount rate should you use?

The textbook definition of WACC suffers from a problem of extrapolating current numbers into the future. Right now interest rates are low, and the risk-free rate is 1.5%. However, we are modeling what the value of Coke will be well into the future –Â to infinity to be exact. It doesn’t make sense to assume current interest rates will stay the same five, 10, 20, 30 or more years into the future.

We all know the problem with beta; it’s a measure of volatility not risk and using it as a proxy for risk can be dangerous. Coke has a beta of 0.51 meaning the stock is about half as volatile as the market. Our question is what happens to Coke’s beta when the market’s mood changes and consumer staples stocks are no longer “in style.” Sure, I doubt Coke will ever have an above-average beta, but it certainly is possible it will increase from its low level.

We are managing money to produce satisfactory returns for clients over long time periods. We want to incorporate a discount rate that reflects that same time period. By choosing a discount rate that is approximately the same as the historical average annual return for the stock market, we can help match our valuations to our clients' time horizons. It also helps us avoid letting market valuations and sentiment or the low interest rate cloud our judgment.

This is not to say that using a static number like 10% for every stock doesn’t have flaws. Some stocks are clearly riskier than others, and the timing and certainty of cash flows can be uncertain. It makes no sense to value a disruptive, fast-growing startup company using the same discount rate as an established defense contractor.

Luckily we have one advantage over an academic model. We can just give up on valuing some stocks. We can admit that the future is just too uncertain to value. We can move on to exploring another possibility for our investment portfolio. That’s how we deal with the problem of using a static discount rate for riskier stocks. We try to limit our investments to companies that have high degrees of certainty of future cash flows.

Disclosure: No positions in any companies mentioned.

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