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%. Personally, I like to include a mix of inflation costs, long term government bond yields, and an equity risk premium.
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.
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. The International Monetary Fund website 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 a website called Market Risk Premia. 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.
