Warren Buffett (Trades, Portfolio) has said many times in the past that one of the processes he uses to calculate the intrinsic value of the company he is considering adding to the Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) equity portfolio is a discounted cash flow analysis. A key component in this calculation is the discount rate.
Discount cash flow forecasts are highly sensitive. A change in the discount rate of just a few basis points can have a big impact on the final figure. Thus, it is essential to use both an appropriate and conservative figure, a figure that reflects both the risk of investment and the current interest rate environment.
Coming up with a discount rate
Buffett has never put a definite figure on the discount rate he likes to use in all calculations. This is probably because it changes from business to business.
For example, when discussing this topic at the 1996 Berkshire annual meeting of shareholders, he suggested that investors might want to use a more conservative rate for a water company over a tech business, even though the cash they both produce has the same utility:
"There may be times, when in a very — because we don't think we're any good at predicting interest rates, but probably in times of very — what would seem like very low rates — we might use a little higher rate. But we don't put the risk factor in, per se, because essentially, the purity of the idea is that you're discounting future cash. And it doesn't make any difference whether cash comes from a risky business or a safe business — so-called safe business.
So, the value of the cash delivered by a water company, which is going to be around for a hundred years, is no different than the value of the cash derived from some high-tech company, that you might be looking at. It may be harder for you to make the estimate.
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. But we believe in using a government bond-type interest rate. We believe in trying to stick with businesses where we think we can see the future reasonably well — you never see it perfectly, obviously — but where we think we have a reasonable handle on it."
Knowing the business
The discount rate is important, but it is not as important as understanding the business in question. If you know and understand what the business does, and it fits squarely within your circle of competence, then you shouldn't need to use a highly conservative discount rate.
The more certainty you have over cash flows, the less likely it is that the company will not meet your growth targets. Therefore, your margin of safety does not have to be as wide.
This is something that's often overlooked in business valuation. It's not the formula that matters the most., it's the reliability of the cash flows. There's so much uncertainty in the world of business, but if you stick with what you know, your chances of making a severe mistake are much lower. It also becomes easier to pick a discount rate as you do not have to factor in uncertainty.
As Buffett summarized in 1996:
"You better just stick with businesses that you can understand, use the government bond rate. And when you can buy them — something you understand well — at a significant discount, then, you should start getting excited."
Disclosure: The author owns shares in Berkshire Hathaway.
Read more here:
- Looking Back at the 3 Stages of Charlie Munger's Investment Career
- How Buffett Analyzes Risk: We Don't Have a Formula
- Mohnish Pabrai: Why Investors Should Operate Alone
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