The Choice of a Discount Rate

The other component of present-value analysis, choosing a discount rate, is rarely given sufficient consideration by investors.

• A discount rate is, in effect, the rate of interest that would make an investor indifferent between present and future dollars. 
• Investors with a strong preference for present over future consumption or with a preference for the certainty of the present to the uncertainty of the future would use a high rate for discounting their investments. 
• Other investors may be more willing to take a chance on forecasts holding true; they would apply a low discount rate, one that makes future cash flows nearly as valuable as today's. 
• There is no single correct discount rate for a set of future cash flows and no precise way to choose one. 

The appropriate discount rate for a particular investment depends not only on an investor's preference for present over future consumption but also on his or her own risk profile, on the perceived risk of the investment under consideration, and on the returns available from alternative investments.

• Investors tend to oversimplify; the way they choose a discount rate is a good example of this. 
• A great many investors routinely use 10 percent as an all-purpose discount rate regardless of the nature of the investment under consideration. 
• Ten percent is a nice round number, easy to remember and apply, but it is not always a good choice. 
• The underlying risk of an investment's future cash flows must be considered in choosing the appropriate discount rate for that investment. 
• A short-term, risk-free investment (if one exists) should be discounted at the yield available on short-term U.S. Treasury securities, which, as stated earlier, are considered a proxy for the risk-free interest rate.
• Low-grade bonds, by contrast, are discounted by the market at rates of 12 to 15 percent or more, reflecting investors' uncertainty that the contractual cash flows will be paid. 

It is essential that investors choose discount rates as conservatively as they forecast future cash flows.

• Depending on the timing and magnitude of the cash flows, even modest differences in the discount rate can have a considerable impact on the present-value calculation. 
• Business value is influenced by changes in discount rates and therefore by fluctuations in interest rates. 
• While it would be easier to determine the value of investments if interest rates and thus discount rates were constant, investors must accept the fact that they do fluctuate and take what action they can to minimize the effect of interest rate fluctuations on their portfolios. 

How can investors know the "correct" level of interest rates in choosing a discount rate?

• I believe there is no "correct" level of rates. 
• They are what the market says they are, and no one can predict where they are headed. 
• Mostly I give current, risk-free interest rates the benefit of the doubt and assume that they are correct. 
• Like many other financial-market phenomena there is some cyclicality to interest rate fluctuations. 
• High interest rates lead to changes in the economy that are precursors to lower interest rates and vice versa. 
• Knowing this does not help one make particularly accurate forecasts, however, for it is almost impossible to envision the economic cycle until after the fact. 

At Times when Interest Rates are Unusually Low

• At times when interest rates are unusually low, however, investors are likely to find very high multiples being applied to share prices. 
• Investors who pay these high multiples are dependent on interest rates remaining low, but no one can be certain that they will. 
• This means that when interest rates are unusually low, investors should be particularly reluctant to commit capital to long-term holdings unless outstanding opportunities become available, with a preference for either holding cash or investing in short-term holdings that quickly return cash for possible redeployment when available returns are more attractive. 

Investors can apply present-value analysis in one of two ways.

• They can calculate the present-value of a business and use it to place a value on its securities. 
• Alternatively, they can calculate the present-value of the cash flows that security holders will receive: interest and principal payments in the case of bondholders and dividends and estimated future share prices in the case of stockholders. 
• Calculating the present value of contractual interest and principal payments is the best way to value a bond. 
• Analysis of the underlying business can then help to establish the probability that those cash flows will be received. 

By contrast, analyzing the cash flows of the underlying business is the best way to value a stock.

• The only cash flows that investors typically receive from a stock are dividends. 
• The dividend-discount method of valuation, which calculates the present value of a projected stream of future dividend payments, is not a useful tool for valuing equities; for most stocks, dividends constitute only a small fraction of total corporate cash flow and must be projected at least several decades into the future to give a meaningful approximation of business value. 
• Accurately predicting that far ahead is an impossibility. 
• Once future cash flows are forecast conservatively and an appropriate discount rate is chosen, present value can be calculated. 

In theory, investors might assign different probabilities to numerous cash flow scenarios, then calculate the expected value of an investment, multiplying the probability of each scenario by its respective present value and then summing these numbers.

• In practice, given the extreme difficulty of assigning probabilities to numerous forecasts, investors make do with only a few likely scenarios. 
• They must then perform sensitivity analysis in which they evaluate the effect of different cash flow forecasts and different discount rates on present value. 
• If modest changes in assumptions cause a substantial change in net present value, investors would be prudent to exercise caution in employing this method of valuation.