If there's more risk, the use of a higher discount rate should account for that risk. Sounds harmless enough so far, right? Here's where it becomes a bit less so. Somehow, a stock's volatility or beta (fluctuation compared to a benchmark) is supposed to be a proxy for risk. Well, at least it is based upon what seems a highly flawed model.
No doubt more than a few who went to B-school have carried this way of thinking into their business and investing endeavors.
Yet Buffett has said he believes none of this makes any sense. So what rate does he use to discount the future cash flows of an investment?
The long-term U.S. Treasury rate.*
"Don't worry about risk the way it is taught at Wharton. Risk is a go/no go signal for us—if it has risk, we just don't go ahead. We don't discount the future cash flows at 9% or 10%; we use the U.S. Treasury rate. We try to deal with things about which we are quite certain. You can't compensate for risk by using a high discount rate." - Warren Buffett at the 1998 Shareholder Meeting
"In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value - in our case, at the long-term Treasury rate. And that discount rate doesn't pay you as high a rate as it needs to. But you can use the resulting present value figure that you get by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of measurement across all businesses." - Warren Buffett at the 1998 Shareholder Meeting
"...we adjust by simply trying to buy it at a big discount from the present value calculated using the risk-free interest rate. So if interest rates are 7% and we discount it back at 7% (which Charlie says I never do anyway — which is correct), then we'd require a substantial discount from that present value figure in order to warrant buying it." - Warren Buffett at the 1997 Shareholder Meeting
To me, the Buffett way of thinking not only makes more sense, it's also less complex and more useful.**
Complexity is fine if it's warranted. It's fine if it has some incremental utility.
So it's using one discount rate to create a common yardstick across different investments, calculating present value using that discount rate, then buying at a substantial discount to that present value to create a margin of safety.
Note that there's no real attempt to quantify risk in the process.
There is no shortage of ideas and formulas that are direct descendants of efficient market theory. Things like the capital asset pricing model (CAPM) -- along with the many other related models, ideas, and theories -- all seem like good examples of formula envy within economics and finance (or what Charlie Munger calls "physics envy"):
"Well, Berkshire's whole record has been achieved without paying one ounce of attention to the efficient market theory in its hard form. And not one ounce of attention to the descendants of that idea, which came out of academic economics and went into corporate finance and morphed into such obscenities as the capital asset pricing model, which we also paid no attention to." - Charlie Munger Speech at UC Santa Barbara
Then, later in the speech Charlie Munger talked about nine different categories of things wrong with economics. Here's what he says is the third weakness:
"The third weakness that I find in economics is what I call physics envy. And of course, that term has been borrowed from...one of the world's great idiots, Sigmund Freud. But he was very popular in his time, and the concept got a wide vogue.
One of the worst examples of what physics envy did to economics was cause adaptation and hard-form efficient market theory. And then when you logically derived consequences from this wrong theory, you would get conclusions such as: it can never be correct for any corporation to buy its own stock. Because the price by definition is totally efficient, there could never be any advantage. QED. And they taught this theory to some partner at McKinsey when he was at some school of business that had adopted this crazy line of reasoning from economics, and the partner became a paid consultant for the Washington Post. And Washington Post stock was selling at a fifth of what an orangutan could figure was the plain value per share by just counting up the values and dividing. But he so believed what he'd been taught in graduate school that he told the Washington Post they shouldn't buy their own stock. Well, fortunately, they put Warren Buffett on the Board, and he convinced them to buy back more than half of the outstanding stock, which enriched the remaining shareholders by much more than a billion dollars." - Charlie Munger Speech at UC Santa Barbara
CAPM adjusts the expected return based upon a stock's volatility or beta. The expected return minus the risk-free rate is the risk premium.***
To me, this way of thinking about risk and return has major defects.
The end result of all this is a discount rate (or expected return) based upon a risk premium that gets added to the risk free rate. Now, academia would view CAPM as insufficient for companies with debt because it doesn't take into account the capital structure. That leads, unfortunately, to weighted average cost of capital (WACC). Well, feel free to explore how to calculate WACC.
The WACC formula attempts to take the capital structure of a business into account.
It's also, if not useless, closer to being that than not as far as I'm concerned.
So the rates calculated via these formulas are intended for discounting whatever the expected cash flows of a business might be.
Unwarranted complexity that adds little or zero insight.
I'm guessing this flawed way of thinking has remained a common practice for so long is simply because so many CEOs, CFOs, and other business executives were taught this stuff in B-school.
An investor can still decide to use a slightly higher discount rate than the U.S. Treasury rate in order to add a margin of safety. A higher rate may also make sense if the investor views the current risk-free interest rate environment to be unusually low and unlikely to be sustainable. Buffett has said as much:
"We don't think we're any good at predicting interest rates. But in times of what seem like very low rates, we might use a little higher rate." - Warren Buffett at the 1996 Shareholder Meeting
Using a higher rate when somewhat less certain about the future stream of cash an asset will generate over time also makes some sense. Buffett even apparently indicated that he does this sometimes at the 1994 shareholder meeting.***
So there's more than one reasonable way to decide what the discount rate should be.
It's just that the higher discount rate need not be adjusted based upon beta, capital structure, or any similarly formulaic approach. The formulas provide a false level of precision that likely means little if anything in terms of real risk and uncertainty.
My own preference is to have a "common yardstick" using one discount rate (based upon a very long-term average of U.S. Treasury rates), then paying a price that provides enough margin of safety -- comfortably below the calculated present value -- based upon my judgment of the specific risks and uncertainties of the investment.
The process of estimating value is inherently and necessarily imprecise. It's highly unlikely that any two investors will come up with the same estimate of value. Some of the more formulaic approaches at least imply that precision can exist where it cannot.
Judgments often must be made based upon important stuff that's not easily quantifiable.
Eventually, an assessment of the risk and uncertainty should result in a go/no go decision. It should not result in the use of a higher discount rate to compensate for that risk and uncertainty.
At some point, no discount rate is high enough.
Buffett has said that he does most calculations in his head, that he deplores "false precision", and with most investments he doesn't rely on exact numbers. It's telling that Charlie Munger claims Buffett never actually does these calculations. It's also telling that Buffett agrees with him.
Charlie Munger (Berkshire Hathaway's vice chairman) said, "Warren talks about these discounted cash flows. I've never seen him do one."
"It's true," replied Buffett. "If (the value of a company) doesn't just scream out at you, it's too close." - from the 1996 shareholder meeting
No matter how one decides to calculate value, keep it simple but meaningful. More importantly, accept that risk and uncertainty is not easily quantifiable.
The discount to estimated value should be quite large and obvious.
Sound qualitative judgments must be made.
* Interestingly, the fair value calculator that I posted on Tuesday will not work with a discount rate as low as the current long-term US Treasury. You have to use a rate slightly higher than a long-term US Treasury rate to make the tool work. The fact that the tool can't even handle such a low rate indirectly makes the point that using Treasury rates as a discounting mechanism for stocks is not the widely accepted practice. The norm is still to add a significant risk premium into the equation.
** Multiply beta by the difference between the expected return of the market and the risk free rate then add to the risk free rate. That, somehow, (well, if you buy this stuff) is supposed to produce the expected return on the asset. Well, that's when beta is actually available. Of course, in the real world -- for many investments -- there is no observable beta. In my experience, this is, at best, interesting to academia only. Usually, the discount rate that ends up being used still is a guess in the 10-20% range depending on perceived risk. Ugh. What a waste of time and energy. My preference is to just discount using the U.S. Treasury rate then separately make a judgment on risk and uncertainty.
*** Buffett said he may vary the discount rate based upon his level of certainty about an investment at the 1994 Berkshire Hathaway meeting. It's an important variation of what he's said at other times and also possibly a bit confusing if not seemingly inconsistent. To me, he's still mostly saying a similar thing. That an investor can't account for risk simply by increasing the risk premium. A higher discount rate just creates some additional margin of safety when somewhat less certain. It's also worth remembering that, unlike the shareholder letters, these are comments made on the fly at the shareholder meetings and may or may not be exact quotes. The comment from the 1994 meeting is still worth noting since it is not quite the same as comments he's made on the same subject at other times.