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Author: TMFGebinr Big gold star, 5000 posts Old School Fool Supernova Phoenix 1
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Subject: More thoughts on discount rates Date: 12/7/2010 12:04 PM
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Hi everyone,

Here's a cross post of a couple of posts over on the MDP: Activision board, where I lay out some more of my thinking on choosing a discount rate.

Cheers,
Jim



Why do people (myself included) use discount rates of 10 - 15%? I understand the formula using beta, WACC, risk free rate, etc., but I don't believe in beta (a measure of volatility and not risk in my book) and also, I'm trying to think of this as if I were buying a business.

Great question and, as always, the answer is "it depends."

There are several schools of thought on it. But basically I think they can be broken down into two viewpoints. What is the risk and what is my return?

One of the "what is the risk?" views uses CAPM, WACC, beta, risk free rate plus equity risk premium, etc. That adjusts the cost of equity (part of WACC, the other part being cost of debt, as I'm sure you're aware) by some risk multiplier (beta). That beta can be the volatility of the stock versus an index, but the value is highly dependent on time-frame sampled, time of day/week/month sampled, number of samples, and index for comparison. Very flawed, in my book. Betas also exist for country risk and currency risk, among other things. Can get pretty hairy and can lead to a false sense of precision. You could do that with your own risk multiplier (beta), based on a judgment of the riskiness of the investment, say multiplying the equity risk premium by 3 for a biotech, 2 for a risky grower, 1 for a mid-cap blue chip, 0.5 for a mega-cap blue chip, or whatever works for you. (This makes more sense to me than using beta from historical volatility which is what CAPM does.)

Another "what is the risk?" view is more along what you outlined. This looks at the stability of the company, the competition, and the likelihood of those future cash flows and adjusts the cost of equity up or down based on a judgment of those risks. A small biotech might use a 15% or 18% (or even higher) discount rate, while a big, stable business like Procter & Gamble might use a 8% or 10% discount rate. If the investment is more like a bond (maybe that cafe you described), then a 7% discount rate might be fine.

The viewpoint I prefer is the other one. "What is my return?" This is more like a hurdle rate. I want my investments to return to me some amount (on average) per year, or higher. Personally, I use 15% because I want to double my investments every five years (outside of adding more funds). So, I often use that as the discount rate -- my required rate of return. I might adjust it up or down a bit for individual positions (using thinking similar to that outlined immediately above), but overall, I want the portfolio to bring in 15% or more, on average, per year. Others might use 12%, wanting to do slightly better than the long-term return of the S&P 500. But I tend to use a consistent discount rate no matter what I'm looking at. Of course, that causes me to pass over a bunch of companies.

Which approach you choose is more a matter of style and investing philosophy than being "right" or "wrong." However, understanding what is done and why is important so that you can intelligently choose what will work for you.



Will you get 15%? When can the investor expect it?

IF (and that's a big if) the company performs as modeled, and IF the market is rational (and you can believe that if you want), then the stock price SHOULD go up by the discount rate each year.

See all the conditionals I put in there? :-)

Trouble is, companies hardly ever perform as modeled, the market is not completely rational -- not even for a big cap like Microsoft -- and stock prices do their own thing over time, but generally rise. But when that rise happens is not determinable.

The probability is that the stock will give that return, on average (that's the key), over several years ("several" being kind of open-ended). For instance, if the stock remains flat for four years and then doubles in the fifth, that averages out to 15% per year compounded. Not very smooth at all. But it's only a probability. The stock could end up doing nothing for a very long time or even go down as new information comes to light.

What I try to do is review the purchase thesis every now and then and check to make sure I haven't missed anything. Following the company, skimming its news, reading the quarterly earnings releases and listening to (or reading) the conference calls, helps in this regard.
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