Effective Business Valuation 99When valuing the cash fl ows that a business will generate years
from now, you need to discount them back to the present to see
what they are worth today. When calculating intrinsic value, you want
to compare the intrinsic value today with the market value today.
There ’ s a never - ending discussion about the appropriate dis-
count rate to use when calculating intrinsic values. Many investors
and the examples in this book use 10 percent as a default discount
rate. Ten percent is often cited as a good multiple because of the
historical market return of 8 to 10 percent a year. And the histori-
cal market return is a function of historical corporate profi t growth
rates, which average in the high single digits when you combine
stable slow growth businesses with younger, more rapidly growing
businesses.
However, the most important consideration when thinking
about applying a discount rate is the reliability of the cash fl ows
over a period of years. More reliable cash fl ows can be assigned
lower discount rates because the lower the discount rate, the
higher the present value of the cash fl ows. This makes sense when
you consider the safest investments on the planet, U.S. Treasuries,
which are bonds that are backed by the full faith and credit of the
United States government. When investors speak of U.S. Treasuries,
they are often referring to the 10 - year note, which yielded 3.75 per-
cent in June 2009. Like our 10 - year low - risk investment chart, if you
buy a $ 1,000 10 - year Treasury note that pays 3.75 percent a year,
you are guaranteed two things: that you will earn 3.75 percent per
year ( $ 37.50) and get your $ 1,000 back after 10 years. U.S. Treasury
notes are similar to certifi cates of deposit at banks, except that your
money is backed by the government.
Since you know that your cash fl ows and principal is guaran-
teed, U.S. Treasury notes serve as an initial starting point for fi gur-
ing out the appropriate discount rate. Corporate cash fl ows are not
as safe and secure as U.S. Treasury cash fl ows, so any discount rate
used to determine the intrinsic value of a business should be higherCH006.indd 99CH006.indd 99 9/2/09 6:58:07 PM9/2/09 6:58:07 PM