What discount rate should be used for Discounted Cash Flow (DCF) analysis? Should it be the risk-free rate? The cost of capital of the investor? The cost of capital of the firm in question (e.g. WACC)? Does DCF give you the fair value of a stream of cash flow? If not, how do you calculate the fair value of a stream of cash flow (e.g. cash flows from a firm)? and what does the resultant DCF value actually mean?
Thoughts on DCF and Valuation:
- The discount rate used should be your required rate of return, i.e. the return you want your inflow of cash to earn.
- Discounting a cash flow stream with your required rate of return, will give you the price that will allow you to get your required rate of return on your money. Note that as cash will be given out in bits and pieces in the future, your required rate of return is only earned by the “remaining money”, i.e. it does not apply to the cash that will be returned in bits and pieces. The re-investment return is a separate issue.
- If you discount a stream of cash flow by the risk-free rate, then the resultant value is the maximum amount of money you should be willing to pay for that cash flow stream (assuming you can borrow and lend at the risk-free rate). If the price of that cash flow stream is higher, then you can replicate it at the lower cost using your risk-free rate. If the price of that cash flow stream is lower, and the stream is risk-free, then that will set the new risk-free rate.
- The price you would be willing to pay for a company is somewhere between its liquidation value, and the DCF of a optimistic scenario using risk-free rate as the discount (upper bound).
- There are only two applications for discounting a cash flow stream by a cost of capital:
- The value you get is a benchmark point. If the price of that cash flow stream < benchmark point, then buying that stream will allow you to earn a rate of return higher than your cost of capital.
- Calculating an LBO value using the cost of capital and EBIT or NOPAT, to make sure cash flows from the company is enough to cover the cost of capital.
- Bruce Wasserstein in Big Deal highlighted that for DCF, cash flows of mature companies are generally discounted at the 12 to 13% level depending on the riskiness of the target’s business.
- What is the fair value of a stream of cash flow? Is that the same as discounting the cash flow stream by a certain discount rate? No. There is no concept of “fair value” for stream of cash flow. Given a stream of cash flow and its price, the only concept is the IRR. Trying to calculate a fair value for the cash flow and comparing with its price, is a useless, redundant thing to do – serves no point. This will eliminate the problem of choosing a subjective discount rate. To compare across different investment opportunities, just compare the IRRs. To select an investment then becomes a matter of picking what IRR you would minimally like to have. According to Buffettology, Buffett’s IRR target is 15%.
- A quote from Buffettology: “To Warren the intrinsic value of an investment is the projected annual compounding rate of return the investment will produce.”
- Note that in Berkshire Hathaway’s Owner’s Manual, Buffett wrote, “Intrinsic value can be defined simply: It is the discounted value of the cash that can be taken out of a business during its remaining life.”, and “… intrinsic value is an estimate rather than a precise figure, and it is additionally an estimate that must be changed if interest rates move or forecasts of future cash flows are revised.”. Makes you wonder whether Buffett performs the typical DCF or my type of DCF.