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.