What's the Discount?

In pretty much any endeavor that looks out toward the future, I take it as a matter of fundamental truth that while the devil may be in the details, he most certainly makes his permanent home in the assumptions. As any analysis of a business for investment purposes is fundamentally concerned with the future, one is confronted with the chore of using historical data to forecast “that which is likely to be.” When the analysis is concerned with a company’s earnings, the weapon of choice is the Discounted Cash Flow (DCF) model. When using discounted cash flow (DCF) analysis to determine a value for a stock, the two primary assumptions one must make are the earnings growth rate and the rate at which future cash flows should be discounted.

An earnings growth rate is very easy to come up with. You can look at a company’s historical performance and in the light of what you consider their future prospects to be, come up with an assumption, that if inaccurate (a synonym for assumption) at least has the illusion of reasonableness. Better yet, use a range of possibilities, thereby adding the illusion of thoroughness to the analysis.

The discount rate assumption, which is often nothing more than a screaming wild-ass guess (SWAG), is one that is better built from the ground up. This gives, not only the illusion of reasonableness but of statistical veracity as well. Here is how I come up with a discount rate.

First, since inflation will make tomorrow’s dollars worth less than they are worth today, a long-term inflation rate is entered into the mix. I use 3%

Next, add in a “risk-free rate of return.” I use the rate on ten-year treasuries, currently 3%. By the way; I round up. This isn’t rocket science, and more places to the right of the decimal adds zero accuracy… which would be the illusion of being an Economist.

To these figures, I add a simplistic weighted average cost of capital (WACC). This number is derived, for debt, by taking a company’s interest expense and dividing it by the debt load. For the equity portion of the WACC, I look at earnings yield. A hypothetical example using five years of data is as follows.

	2008	2007	2006	2005	2004
Average Mkt Cap	$ 16,650	$ 16,550	$ 15,600	$ 9,200	$ 6,500
ST Debt	$ 200	$ 25	$ -	$ -	$ -
LT Debt	$ 3,000	$ 2,250	$ 900	$ 1,600	$ 900
Total Debt	$ 3,200	$ 2,275	$ 900	$ 1,600	$ 900
Total Equity	$ 7,900	$ 5,000	$ 4,800	$ 4,300	$ 3,500
Total Capital	$ 11,100.0	$ 9,550.0	$ 6,600.0	$ 7,500.0	$ 5,300.0
Interest Expense	$ 135	$ 50	$ 40	$ 35	$ 25
Net Earnings	$ 1,800	$ 1,500	$ 1,800	$ 1,300	$ 1,100
						Mean
Interest Rate	4%	2%	4%	2%	3%	3%
Earnings Yield	11%	9%	12%	14%	17%	12%
WACC	9%	5%	9%	9%	12%	9%

In the above example, I have calculated a WACC of 9% to which I add the previously assumed inflation rate and the risk free return rate, yielding a final discount rate of 15%. Now off to the forecasting races!