My take on Valuation is very simple and coincide with how Warren Buffet explains it. A Discounted Cash Flow model is the ONLY way to Value a stock. I am comfortable making this bold claim. If you have read ‘The Intelligent Investor’, Ben Graham explains the same as well.
Think about what happens when you attempt to do a DCF:
If you can project the cash flows comfortably, you have nothing to worry. Discount them. This should give you the perfect intrinsic value of the company.
If you think your Valuation numbers look slightly off, replace all the numbers with conservative estimates. It’s better to be roughly right than to be precisely wrong.
If you think you are unable to predict the cash flows at all, don’t value the company. Maybe someone else can. You can’t. So let it go.
Always use a Margin of Safety, just to avoid the ever-present danger that you overlooked something or some number in your Valuation distorted the Value.
But what should be the discounting rate?
In an ideal world, the discounting rate you use for Valuing any Asset should be your “Opportunity Cost”. However, finding out your Opportunity Cost is very difficult. An Opportunity Cost is something you can earn with certainty. In other words, an Opportunity Cost is a Personal Risk-free Rate.
Let’s say you own a piece of land. You are very sure that the value of the land will increase by 9% every year. You are not so sure about your other investments increasing by this much. So when you consider investing in a stock, you are foregoing a guaranteed return of 9% (Which you can get by investing in a nearby piece of land). Hence, you should use 9% as the discounting rate.
If you are not sure about the returns from any of your investments, you should ideally use the Risk-free Rate (+ a few Basis points, because interest rate don’t stay the same always). Currently, in India, this could be 7.29% (Risk-free Rate) + 50% = 11% (Just an example). You should use 11% as your discounting rate.
What we learn from all this discussion is that – discounting rates should not be the point of focus. You already kind of know the range for the discounting rates – in India it starts from 7.29% and probably stops at 11% or 12%, beyond which the ‘certainty’ factor takes a hit. If you are an investment genius like Rakesh Jhunjhunwala, you might consider a higher Discounting Rate. As a personal note, I stick with Ben Graham. I use “Risk-free Rate + a few Basis Points” as my discounting rate.
Quoting Prof. Aswath Damodaran to understand the importance of Discounting Rates:
“While discount rates obviously matter in DCF valuation, they don’t matter as much as most analysts think they do.”
Quoting Warren Buffet to round things up:
“The trouble isn’t that we don’t have one [a hurdle rate] – we sort of do – but it interferes with logical comparison. If I know I have something that yields 8% for sure, and something else came along at 7%, I’d reject it instantly. Everything is a function of opportunity cost.”
The following article offers key insights into how Charlie Munger and Warren Buffet think about Discount Rates:
The following article is very interesting and explains Discounting Rates easily for investors:
The following article is written by Prof. Sanjay Bakshi and explains why one shouldn’t use very high discounting rates or P/E, P/B multiples to do Valuation:
Found this wonderful article, which is a collection of a lot of instances when Warren Buffet has discussed Discounting Rates: