# Discount Rates & Valuation (#2)

### Discount rates imply a future expected return. Investors need to think carefully about what that means.

In my first newsletter I covered Hingham Institution for Savings, an incredibly well-run bank headquartered in Massachusetts. I’ve since had some feedback from readers, all of which was positive and much appreciated. One comment from a reader led to this post, which was the fact that I didn’t give a specific value for HIFS. Here’s why I’m reluctant to point to a specific value for *any *company, even ones I buy for myself and clients.

* 1) Valuation is an exercise in imprecision.* If you have to bring it out to even one decimal point you’re probably buying something a) you don’t fully understand, or b) too close to intrinsic value (i.e. without a proper margin of safety).

I gravitate toward the approach pioneered by Bruce Greenwald of Columbia University, which seeks to break down the components of value into a value for i) assets, ii) earnings power, and iii) growth.

For HIFS that meant a book value of $293 million and an earnings power value of $410 million. The way I handled growth was to back into an implied growth rate based on my assumed 10% discount rate.

* 2) Discount rates are investor/opportunity specific. *For my exercise, I used a discount rate of 10%. Another investor might have a higher or lower discount rate. Or they might have such good companies in their portfolio that a 10% return would be a step down from the opportunities already available in their portfolio today.

**3)** The main point of this post is that discount rates imply a future expected return. Investors need to think carefully about what that means. To use a simplified but tangible example, if I say a series of future steady-state cash flows of $10 per annum are worth $100, that takes into consideration the 10% discount rate I’m using and my expectations for the future. It means if I pay $100 I’ll get a 10% return. Fair enough.

Problems arise when discount rates are forgotten or pushed to the background. I’ve seen too many investors use a low discount rate and expect high future returns. To return to our example, if I use a 5% discount rate, that puts the “value” of those same $10 annual cash flows at $200. * Here’s an important point: If I pay $200 for those cash flows I can’t get more than 5% (all things being equal here). I’m accepting my discount rate by buying at that price. *Continuing this example, if the security were available for $150, it’d be at a 25% discount to “value” but since the cash flows don’t change it represents a 6.7% return.

True, if the market uses a 5% discount rate and the security goes to $200 you’ll make 33%. But that introduces a degree of risk and speculation, and depends on how quickly things revert, if at all. I don’t know what interest rates nor the market will do. As a business owner, I’m looking to buy knowable cash flows at a good rate of return.

To conclude, in future newsletters I’ll try to do a better job giving readers a sense of the range of values I see, and perhaps how tight a range I consider appropriate. My main focus will be giving you the facts to draw your own conclusions as to the quality of the underlying business and its cash flows.

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