On Discount Rates
In this post I want to opine on discount rates and how I use them in my investing process. In simple terms, a discount rate is the anticipated long-term rate of return on an investment. Typically, the discount rate is applied to an estimated earnings figure to derive the value of a stock. Examples of this are the commonly used discounted cash flow analysis, or the Bruce Greenwald valuation approach that I often use. Essentially, it's a way to determine how much future earnings are worth in today's terms.
Now, determining the appropriate discount rate involves a degree of subjectivity. For some investors, it might be a personal preference, aiming for a desired return, say, 10%. Alternatively, the Weighted Average Cost of Capital (WACC) is commonly used, factoring in both the cost of debt and equity. For our purposes, discount rates and costs of equity are basically the same thing; they are the returns an investor desires.
Another aspect of discount rates and calculating WACC is to start with the risk-free rate, plus an equity premium. For example, if the risk-free rate stands at 2%, a high-quality large-cap stock might warrant a 5% discount rate (ie 20x earnings multiple), while a smaller or lower-quality stock could demand an 8% discount rate. A higher discount rate is required since the investment is perceived by large investors as being “risky”. Recently, with short-term rates hovering around 5%, the dynamics have shifted. I would expect quality stocks to trade for a valuation that implies a 7-8% discount rate, while lesser-quality ones might command around 10% (although to some degree this is not happening in the market).
What's crucial to understand is the inherent subjectivity of discount rates. It's not just about personal preferences; institutional investors, like pension funds, operate on different expectations. For instance, as someone managing a relatively concentrated portfolio with smaller sums of money, I have the flexibility to explore opportunities that might not be viable for large institutional investors. Despite this, when valuing a stock, I still use a discount rate akin to what a pension fund might employ.
Let's consider an example: if I estimate a stock's earnings at $5 and use a 10% discount rate, its value would be $50 per share. However, my strategy typically involves waiting for the market to turn sour on the company, perhaps such that I could buy the stock 70% of fair value. That would mean buying the $50 stock for $35. In this scenario, if I hold onto the stock for the long term, effectively, I'm treating it as if it were valued at a 14% discount rate.
In practice, I often buy a stock that is trading below its fair value, then sell it once it eventually reverts back to fair value, or maybe becomes overvalued. In our example, this would mean buying at $35 and making $15 when the stock reverts to fair value, which comes out to be a 43% gain. The difference here is the holding period. The discount rate applies to long-term holdings, whereas this trade often takes about a year to play out. That being said, the merits of holding stocks for longer term, or “value trading” them once they revert to fair value is a topic for another day.
The key point is that valuing a stock using an institutional investors discount rate, then buying below that fair value, and buying the stock with my personal discount rate are two sides of the same coin. At the end of the day, I’m valuing the company based on how I think the market would value the company. But I wait until the stock goes on sale so that it provides a return that matches my personal discount rate.