Thursday, August 23, 2007

The Effect of Discount Rates on Intrinsic Value

The discount rate you use in a discounted cash flow valuation can have a big effect on an intrinsic value calculation. To illustrate, let's use an example based on the following assumptions:
Earnings Per Share Year 0: $1.00
Growth Years 1-5: 12%
Growth Years 6-10: 10%
Growth Years 11-15: 8%
Growth Years 16-20: 6%
Growth Years 21-25: 4%
Growth Years 26-30: 2%
Under this scenario, the net present value of those 30 years worth of earnings is $45.65 using the current risk free rate of 6% (even though the current risk free rate is lower, it is prudent to use 6% as a minimum) as our discount rate.
However, if we change the discount rate to 10%, the value of that earnings stream is now only worth $26.43. Furthermore, if we bump the rate up to 15%, the net present value is knocked down to $15.40.
So, discount rates have a big effect on valuation and that means that interest rates (which help determine appropriate discount rates) have a big effect on valuation. And as if that doesn't make things difficult enough, here's another fact: you can't predict interest rates over time.
This is just further proof of the importance of only purchasing a security (or entire business) when you have a LARGE Margin of Safety between current price and intrinsic value, and it also stresses the fact that one should wait for a fat pitch before taking a swing while investing.