The Business of Value Investing.pdf

100 The Business of Value Investing

than 3.75 percent. The issue then becomes what rate is appropriate:

5 percent, 10 percent, 15 percent, or something else?

This is when investing becomes part art and part science. If

you use too low a discount rate, then lots of not - so - great businesses

will look cheap relative to the intrinsic value. Use too high a dis-

count rate and every business looks overpriced. While many bril-

liant investors advocate using 10 percent as a discount rate, in no

way should it be the default rate at all times. You have to account

for the riskiness of the cash fl ows. A start - up company could eas-

ily be valued at a 25 percent discount rate while a business like

Coca - Cola could be valued using something less than 10 percent.

You can be comfortable knowing that the world will continue to

drink Coke, and you have decades of cash fl ow generation to back

you up. But if you ’ re trying to value a new restaurant chain, you

have to account for the lack of operating history, future competi-

tive threats, and so on. I wish there were a scientifi c formula for

applying discount rates, but if there were, investing wouldn ’ t be

investing.

The other companion to the discount rate is the growth rate in

the cash fl ows. By now you might conclude that a 10 percent discount

rate for the movie - store example was too low a fi gure. The example

was used to illustrate the signifi cance of intrinsic value and the mar-

gin of safety. Based on the competitive landscape for movie rentals,

however, 10 percent was not an appropriate discount rate, especially

if we are assigning a 10 percent discount to the low - risk investment. A

much higher discount rate would need to be applied in order to get

a more conservative intrinsic value for the movie store.

Ideally if you are investing in a business, you are doing so

because you are confi dent that, over time, the business will be earn-

ing more profi ts and thus generating higher levels of cash fl ow. But

again, projecting cash fl ow growth rates is also an estimate and an

estimate can easily be different from the actual future results.

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