Question: When you estimate intrinsic value in capital intensive companies like McDonald’s and Walgreens where a very healthy and growing operating cash flow is largely offset by expenditures for new stores, restaurants, etc how do you estimate future free cash flow? And at what rate do you discount those cash flows?
Warren Buffett: We use the same discount rate across all securities. We may be more conservative in estimating cash in some situations.
Just because interest rates are at 1.5% doesn’t mean we like an investment that yields 2-3%. We have minimum thresholds in our mind that are a whole lot higher than government rates. When we’re looking at a business, we’re looking at holding it forever, so we don’t assume rates will always be this low.
Source: BRK Annual Meeting 2003 Tilson Notes
We don’t formally have discount rates. Every time we start talking about this, Charlie reminds me that I’ve never prepared a spreadsheet, but I do in my mind.
We just try to buy things that we’ll earn more from than a government bond – the question is, how much higher? If government bonds are at 2%, we’re not going to buy a business that will return 4%.
I don’t call Charlie every day and ask him, “What’s our hurdle rate?” We’ve never used the term.
Munger: The concept of a hurdle rate makes nothing but sense, but a lot of people using this make terrible errors. I don’t think there’s any substitute for thinking about a whole lot of investment options and thinking about the returns from each.
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. It’s like the mail-order-bride firm offering a bride who has AIDS – I don’t need to waste a moment considering it. Everything is a function of opportunity cost.
Buffett: I’ve been on 19 boards and seen a zillion presentations projecting a certain IRR [internal rate of return]. If the boards had burned them all, they’d have been better off. The IRR is based on what the CEO wants. The numbers are made up.
Munger: I have a young friend who sells private partnership interests to investors, and it’s hard to get returns in that field. I asked him, “What returns do you tell them you can get?” He said “20%.” I said, “How did you come up with that number?” He said, “If I told them anything lower, they wouldn’t give me the money.”
Buffett: There’s no one in the world who can earn 20% on big money. It’s amazing how gullible pension funds and other investors are. They want it so badly that they’ll believe even total nonsense.
Source: BRK Annual Meeting 2007 Tilson Notes
Discount rates used for valuation:
– Use a long term normalized interest rate for Treasuries…e.g. 6%
– Don’t use different discount rates for different businesses…it doesn’t really matter what rate you use as long as you are being intellectually honest and conservative about future cash flows.
– Only want one variable to compare in order to assess the viability of an investment – price versus value. If we allowed discount rates to change it would lead to more than one variable.
– WB’s assessment of the risk of a company is baked into the probabilities for future cash flow scenarios of the company
– “I don’t know what the true cost of capital is for a business unless we own it”
Source: Meeting with Warren Buffett, Jan 28 ,2005