Monday, November 23, 2015

"Why and how do Munger and Buffett “discount the future cash flows” at the 30-year U.S. Treasury Rate?"

From 25iq:
Buffett and Munger use several methods which are at odds with traditional financial theory. Here is one of those nontraditional approaches:

Buffett: “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.”

There is no law of nature requiring that a capital allocation process account for risk, uncertainty and ignorance by adjusting the interest rate. Buffett and Munger instead use the concept of margin of safety. Having a margin of safety and also adjusting the interest rate would be redundant in their view. They: 
1. Assemble options to invest that involve businesses which have a future that is “quite certain” and is within their circle of competence
2. Use the 30 year rate to do the DCF in their head on all these opportunities
3. Apply a margin of safety
4. Compare every option available to then anywhere on Earth and chose the best one.

This makes some people nuts since they were trained to adjust the interest rate to account for risk. I’m not taking a personal position here and am instead trying to better explain the Buffett/Munger approach.

The two methods are different ways of accomplishing the same thing, so why do Buffett and Munger use their own approach? I believe they prefer their method since it frames the ultimate question in a way that they prefer. They hate the idea of someone saying “invest in X since the return is above your hurdle rate” since that decisions can be made only by looking at every other alternative in the world. By using the same 30 year US Treasury rate for every DCF he has created a “system to compare things.” The things Buffett compares side-by-side must be “quite certain” and available to buy at a significant discount to intrinsic value reflecting a margin of safety.

My friend John Alberg a co-founder of puts it this way:

“Another way of saying it is that all investments share the same discount rate. You can’t apply a different discount rate to company A than company B because $1 in the future is worth the same amount of money regardless of whether it comes from company A or B. So instead an investor should focus on the cash that a business can generate within a margin of safety and compare them by that measure. With respect to DCF, the reason that it can be “done in the head” is because it simplifies to a simple ratio when you use margin of safety. That is, if most future cashflows from company A are going to be greater than some number c_A and the discount rates are going to be greater than some other value r then the quantity c_A / r is less than the result you would get from a DCF. Put another way, the quantity c_A / r is a lower bound on the DCF or it is an estimate of intrinsic value with a margin of safety. But notice that if you are comparing the intrinsic value of two companies with cashflows of at least c_A and c_B then the discount rate r is constant between the two and therefore not the important part of the equation.”

Buffett and Munger have a flow of deals that cross their desks. We don’t see them but Byron Trott recently said that many investors would cry over losing what they turn down. That flow established their opportunity cost. 30-year US treasury rates can be 3%, but if they have a flow of deals that return 10% that is “sort of” their hurdle rate.

Munger: “We’re guessing at our future opportunity cost. Warren is guessing that he’ll have the opportunity to put capital out at high rates of return, so he’s not willing to put it out at less than 10% now. But if we knew interest rates would stay at 1%, we’d change. Our hurdles reflect our estimate of future opportunity costs.”...

HT: Value Investing World