Buffett has been frequently quoted to use the long-term U.S. Bonds as his discount rate for doing his DCF calculations.
At the 1997 Berkshire Hathaway meeting, Buffett was quoted to have said:
“We use the risk-free rate merely to equate one item to another. In other words, we’re looking for whatever is the most attractive. In order to estimate the present value of anything, we’re going to use a number. And, obviously, we can always buy government bonds. Therefore, that becomes the yardstick rate.”
Responding to a question at the meeting, he was quoted to have said:
Shareholder: Following up on that other question – if you don’t adjust for risk by using higher discount rates, how do you adjust for risk – or do you?
Buffett: Well, we adjust by simply trying to buy it at a big discount from the present value calculated using the risk-free interest rate. So if interest rates are 7% and we discount it back at 7% (which Charlie says I never do anyway — which is correct), then we’d require a substantial discount from that present value figure in order to warrant buying it.
At the 1998 Berkshire Hathaway meeting, Buffett was quoted to have said:
“We don’t discount the future cash flows at 9% or 10%; we use the U.S. treasury rate. We try to deal with things about which we are quite certain. You can’t compensate for risk by using a high discount rate.”
“In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value – in our case, at the long-term Treasury rate. And that discount rate doesn’t pay you as high a rate as it needs to. But you can use the resulting present value figure that you get by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of measurement across all businesses.”
By this time, you would probably think that Buffett simply uses the long-term Treasury rate, while ensuring that the projected cash flows are pretty certain so that you don’t have to increase the discount rate to compensate for earnings risk. However, at the 1994 Berkshire Hathaway meeting, Buffett was quoted:
“In a world of 7% long-term bond rates, we’d certainly want to think we were discounting the after-tax stream of cash at a rate of at least 10%. But that will depend on the certainty that we feel about the business. The more certain we feel about the business, the closer we’re willing to play. We have to feel pretty certain about anything before we’re even interested at all. But there are still degrees of certainty. If we thought we were getting a stream of cash over the thirty years that we felt extremely certain about, we’d use a discount rate that would be somewhat less than if it were one where we expected surprises or where we thought there were a greater possibility of surprises.”
This is clearly inconsistent with his remarks in 1997 and 1998 where he said he does not adjust the discount rate depending on the riskiness of the projected cash flows. Also, in the 2000 Chairman’s Letter, he wrote:
“The oracle was Aesop and his enduring, though somewhat incomplete, investment insight was “a bird in the hand is worth two in the bush.” To flesh out this principle, you must answer only three questions. How certain are you that there are indeed birds in the bush? When will they emerge and how many will there be? What is the risk-free interest rate (which we consider to be the yield on long-term U.S. bonds)? If you can answer these three questions, you will know the maximum value of the bush – and the maximum number of the birds you now possess that should be offered for it. And, of course, don’t literally think birds. Think dollars.”
Meaning that discounting with the risk-free rate results in a value which is the way way upper bound of what you should paying. In conclusion, I believe, if you want to discount, we should look at this in two ways (among many others), first is discounting using the risk-free rate followed by a substantial discount, second is to discount with a higher required rate of return (which Buffettology said Buffett’s was 15%). I still feel that simply calculating the IRR would be the best method.
Also, I still don’t understand why people discount cash flow with WACC. I don’t believe in CAPM and hence the cost of equity. The CAPM is simply a theoretical construct based on assumptions, which are by definition, assumptions that do not conform to reality.
Journeys of a Bumbling Trader 
Thank you for this post. I searched Google for quotes on Buffett’s discount rate and this is perfect. However, I disagree with your final conclusion where you say you don’t believe in CAPM and hence the cost of equity, because they are not necessarily the same thing. I do not believe in beta and hence the CAPM, but that does not mean that a cost of equity does not exist. Simply put, if a company’s bonds are paying 5% then an investor would have to expect to earn more than that on the equity in order to buy it. If an investor bought the equity expecting to earn 5% or less over his or her holding period then that person should rightfully be considered a complete moron. That would be like buying junior debt yielding 4% rather than the same company’s senior debt yielding 5%. It makes no sense to take on the added risk for less return. I think a more logical approach to the cost of equity, rather than using beta, is to simply add a premium to the prevailing market yield associated with the company’s corporate credit rating. Notice I did not say the credit rating and yield of the company’s bonds, because individual bonds can be structured to have a higher credit rating than the company itself.
Posted by James | February 18, 2013, 8:40 amThat’s a fair point, but you have to adjust for economic parameters as well as a AAA Treasury bond isn’t the same as CCC Corporate bond. I think the point he is trying to make is that to even consider buying the company it has to have a AAA stock rating which makes it just as good a investment as a treasury bond i.e coca cola. From this he can assume that the stock can still perform for 30 years and can accordingly discount back to 30 years. If you were to invest in a High yield bond fund then that is different as you are investing in 90 – 150 companies and usually the default level is less than 2% so you can use CCC/BBB bond funds for DCF which is a good way to value. The problem with a bond fund is that the prices are pretty relative and 10 years is a long time horizon and if treasury bonds are are yielding 1-2% then that is a good indicator of demand and economic liquidity where company stocks look a strong growth prospect for price appreciation. I.e you can compare the europe to the usa and china on there government bonds. Treasury bonds at 1-2% expect low yield on big companies around 2-3% and good potential for DCF. Also expect strong emergence of new securities of CCC/BBB bonds.
Posted by AATIQ | March 1, 2013, 3:48 amYour last paragraph “Also, I still don’t understand why people discount cash flow with WACC. I don’t believe in CAPM and hence the cost of equity. The CAPM is simply a theoretical construct based on assumptions, which are by definition, assumptions that do not conform to reality.” Could have been writen by me. My thoughts exacly.
Posted by Nuno | November 27, 2014, 3:31 pmThank you so much for this article. I’ve been puzzled by this question of what discount rate to use for a long time. Also it sounds like you have read the past meeting notes from which you’re quoting. Could you please email a copy or the links? Many thanks!
Posted by Jeff | May 3, 2015, 10:02 pm