Discount Rates: Look Out Below
One of the main reasons why equity markets have been selling off in recent months is the fact that discount rates are increasing. Discount rates are an integral part of calculating an intrinsic value for equities. As Warren Buffett (Trades, Portfolio) once said, when valuing businesses, What matters is the discounted value of cash flows from now until judgment day.
The discount rate used in valuation calculations is incredibly important. A low discount rate will give you a high equity valuation as cash flows will be worth more in the future than they are today. Meanwhile, a high discount rate will give you a much lower valuation because cash flows will be worth less in the future than they would be at a lower rate.
Buffett has said that he likes to use the U.S. Treasury rate as his preferred discount rate with an adjustment for uncertainty. Other common considerations include inflation and interest rates, with interest rates being particularly important to account for when it comes to companies with a lot of floating-rate debt, or those which may need to take out more debt to pay off existing debt on a systemic basis.
Focusing in on Buffett's method, in order to illustrate how moving Treasury rates will impact the valuation of equities, I want to use an example from the past year.
Sudden market movements
This time last year, the yield on the U.S. 10-year Treasury was around 1.5%. If we plug this figure into GuruFocuss discount cash flow calculator as the discount rate for Apple (NASDAQ:AAPL), we get a fair value of $335 per share, an increase of 58% over the current share price. This is assuming a growth rate of 10% per annum in free cash flow for the next 10 years.
However, today, the 10-year Treasury yield stands at 3.7%, although it nearly topped out at 4% earlier in the week. Using this number, the intrinsic value estimate falls to $255, with growth rates kept the same. At a rate of 4%, the intrinsic value estimate drops to $246.
Some analysts are projecting that the Federal Reserve could increase interest rates to around 4.75% next year. This could translate into a 10-year treasury yield of 5.5% or more. Using this figure in the discounted cash flow calculation gives an intrinsic value of $207 per share. Suddenly, Apples intrinsic value is 42% less than it was at the 1.5% discount rate!
I should point out at this stage that quite a lot of this valuation process, estimating discount rates and growth rates, does involve guesswork. There is no guarantee the company will grow free cash flow at a compound annual rate of 10% indefinitely. And there is no guarantee the 10-year Treasury yield will hit 5.5% next year.
Moreover, there is no guarantee that just because my calculator shows that Apple is worth $207 in one scenario, it will actually be worth that much. Still, this example does illustrate how market perceptions of businesses can change in a rising interest rate environment.
Dont rely on discount rates
The moral of this story is, don't calculate the intrinsic value of a stock as if the discount rate and growth will stay the same forever. Valuing businesses is not a science. It is an art. A lot of experience, research and analysis is required to try and come up with an estimate of intrinsic value. It is not as simple as plugging one or two numbers into a calculator and hoping for the best.
A company is ultimately worth as much as investors are willing to pay for it. That means it is at the mercy of the mark environment to some extent. Ultimately, the only reliable source of growth is the business itself, not the movements of investor sentiment.
Higher discount rates could really impact the long-term valuation of a business for some time to come. I don't think the worst is over yet. If investors can get a guaranteed return of 5.5% from bonds, they are unlikely to turn to speculative technology stocks with uncertain futures. This may push down the valuation of the entire technology sector.
I have no doubt great businesses like Apple (NASDAQ:AAPL) will continue to create value in the long run. However, for the next 12 to 24 months, it is going to be incredibly difficult to understand and calculate their underlying intrinsic value and how much wealth they can ultimately create for shareholders.
This article first appeared on GuruFocus.
