Podcast Transcript

Today I will talk about the Discount Rate, also known as the Investors Required Return or even Opportunity Cost. By including a Discount Rate in your Intrinsic Value calculation, you provide yourself with a buffer against things like inflation and investment risk. By purchasing a company at its Intrinsic Value, you should expect to receive a minimum return which includes an offset against inflation and also allow for the inherent risk associated with the purchase of the business. It could be a good idea to have a minimum Required Return of at least 8 – 10%, Warren Buffett suggests a minimum required return should be at least 10%, whereas I apply a minimum required return of 12%.

One of the components of your Discount Rate should reflect the return that is available from a risk-free investment. Investors will generally think of a risk-free return as being the return available from investing in long term government bonds (usually 10-year duration). These days there is an alternative to investing directly into government bonds which is afforded by low cost broad market index funds, commonly known as ETF’s which are listed on the stock exchange. Given the market has returned on average, between 8% and 10% a year for the last 100 years, the market return could be seen as a good basis to decide what your discount rate will be, however at a higher risk than a government bond due to the fact that your return is not guaranteed. Both of these could be seen as an opportunity cost as they are both simple ways which require little research and involvement to invest your money.

Personally, I like to include a mix of inflation costs, long term government bond yields, and an equity risk premium. I will explain further what each of these are and where you can find the data.

I would also like to note that the Discount Rate is what we will be using to calculate a company’s Intrinsic Value. A Discount Rate is used to discount the projected future cash flow of the business to a present value. Basically, one way to calculate the Intrinsic Value of a company is to forecast future earnings for each year for the life of the business, then add these together to give us the Intrinsic Value of the business. But if we don’t discount those future earnings into the present value, the valuation will be grossly overpriced. As we know, due to inflation and other factors one dollar today does not buy you as much as it did 20 years ago.

For an example, let’s use a hypothetical company called ‘Leo’s Lemonade’. After the first year in business Leo produced $100 of free cash flow from selling his lemonade. Free cash flow is the money that is left in the business after all expenses have been paid like taxes, wages, interest expenses, maintenance etc. Leo expects to grow his business and expand his free cash flow at a rate of 10% a year for the next 10 years when finally, the company will be sold as Leo has to move away to attend University. For this example we will use a Discount Rate of 12%. Running these figures using a Discount Cash Flow valuation method, we believe that when Leo sells his business in ten years’ time it will be worth about $1,750. But that is the value of the business in 10 years’ time, so to express that into today’s dollars we will need to discount that valuation using the 12% Discount Rate. This gives the business a current Intrinsic Value of about $900. I will show you how to calculate the Intrinsic Value in more depth in a later Episode.

I will now summarise the three main components I use when establishing the Discount Rate.

First we have inflation. Inflation is basically the rate at which the value of your cash is decreasing each year due to the cost of goods rising, this could also be expressed as the loss of purchasing power. The Discount Rate should take into account expectations of inflation, which has averaged 3% per annum over several hundred years. At the conservative end an inflation rate of 5% would be appropriate. It is important to include inflation in your discount rate as not to do so would mean that the calculated future returns would be overstated when expressed in today’s dollars.
I have provided a link in the show notes to the International Monetary Fund website which has historical inflation data for each country. http://www.imf.org/en/countries

Our second component is the Risk Free Rate. The risk-free rate is accepted as being the current yield of a long-term government bond, generally of 10 years or longer duration. Value Investors deem this as the highest risk-free return that you could receive from an investment. That is why it is used in calculating your Discount Rate, for it wouldn’t make any sense to invest in a risky investment like the stock market, if you didn’t take into consideration other returns that are available to you that have next to no risk. The reason it is deemed ‘Risk Free’ is because it is backed by the government. The chances of the government defaulting and not repaying your loan is slight, although not unheard of.

To obtain the current Risk Free Rate, I use the same website used to obtain the Equity Risk Premium called Market Risk Premia, I have a link in the show notes.
http://www.market-risk-premia.com/market-risk-premia.html

Finally the last component of the Discount Rate takes into account the risk of the investment, known as an Equity Risk Premium. The Equity Risk Premium is the difference between what you expect to receive on your investment compared to a long term ‘no risk’ government bond. To obtain the equity risk premium you simply calculate the expected return on an investment, minus the risk-free rate. This figure is included in your Discount Rate to ensure that the price you pay can be expected to exceed the returns you would have otherwise achieved from a risk-free bond. The market’s Equity Risk Premium over the last few decades has ranged between 4% and 6% per annum.

You can calculate the Equity Risk Premium for each individual company, as not all companies carry the same level of risk or you can use the current market’s Risk Premium. I use the market’s risk premium and obtain that from a website called Market Risk Premia, I have provided a link in the show notes. The site uses the current stock market return as a whole and deducts the current risk-free rate from that.
http://www.market-risk-premia.com/market-risk-premia.html

So, to sum things up, we now understand the importance of calculating the Investor’s Required Return, which is to help mitigate the risk of investing on the stock market. By including Inflation we will cover the losses inevitably incurred by the continuing rise in the price of goods, e.g. loss of purchasing power; having an Equity Risk Premium insures that we will only take on those investments that can achieve high enough returns to compensate for the risk of equity investments and finally, the Risk Free Rate will ensure that we include a return that is available from a ‘risk free’ investment which is usually represented by the yield from a 10 year government bond.

Basically, our Discount Rate is the sum of these three figures, Inflation, Equity Risk Premium, and the Risk-Free Rate. So, let’s take the long-term average Inflation of 3%, and an Equity Risk Premium of 6% plus the current 1% yield on the government bond and we get a Discount Rate of 10%. This falls below my minimum rate of 12% so I would disregard the calculated rate and opt to go with my minimum Discount Rate of 12%.