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Introduction

You create models to project how operating and financial decisions will affect the free

cash flows of your firm. In other words, you want to know the cash you expect to be

consumed in early years and the cash you expect to be produced in later years as a result

of your operating decisions.

Just comparing the patterns of future free cash flows from one scenario to another is

helpful: You want more cash sooner, with as little risk as possible, and you want to avoid

the risk of running out of cash.

Still, in order to more easily compare one scenario to another, you need to reduce these

future cash flows into a single number, a discounted intrinsic value that adjusts for the

risks inherent in each scenario and the time value of money for investors. This means that

you need a discount rate to apply to the cash flow projections.

But how do you choose the right discount rate for a series of free cash flows? Some

believe that the capital asset pricing model (CAPM) yields the best answer; others prefer

the higher 50% to 75% discount rates used in the venture capital valuation method.1

Warren Buffett is widely recognized as one of the wisest investors of this century. He

reportedly uses a 9% discount rate, regardless of the riskiness of the investment or the

current levels of interest rates and inflation. How can such a smart and successful

investor use such a simplistic approach?

In calculating a discount rate, the capital asset pricing model uses the past instability of

the prices of a publicly traded stock as a proxy for future risk, and uses this to adjust the

risk free rate to determine a discount rate.

The CAPM captures the historical volatility of the stock in a term called “beta,” then uses

beta to calculate how much return an investor should demand over the risk-free rate2 for a

1

See Note on Valuation (FEE) for more information on valuation methods.

Copyright 2007 by the Acton Foundation for Entrepreneurial Excellence. No part of this publication may be reproduced, stored in a

retrieval system, or transmitted in any form without the written permission of Jeff Sandefer or the Acton Foundation for

Entrepreneurial Excellence, 515 Congress Avenue, Suite 1875, Austin, TX 78701.

The AFEE curriculum is used in its entirety at the Acton School of Business, based in Austin, Texas, an intense one year program

taught exclusively by successful entrepreneurs. To learn more, visit www.actonmba.org.

given investment. The higher discount rate compensates investors for the risk inherent in

an “unstable” stock.

The CAPM may provide a sense of security to those who are mathematically inclined,

but it has serious drawbacks. The fact that a stock was stable or erratic in the past may

have little relevance in predicting its future performance. Consumer tastes change,

technological breakthroughs occur, and competitors adjust their strategies with little

regard for what happened yesterday.

Most bargain-hunting investors would assume that a stock that has fallen to new lows

could be a bargain; the CAPM holds that a stock that has fallen rapidly in value is

inherently worth less than a similar company with a far higher stock price.

CAPM is even more difficult to use for private companies or discrete projects, because

you first must find a public company whose beta will act as a proxy for the risk of the

non-public venture. For an accurate comparison, you must adjust for differences in

liquidity, size, and innumerable other factors.

Venture capitalists face many challenges when calculating a discount rate. Early-stage

ventures often fail. Entrepreneurs are almost always optimistic about the timing and

magnitude of future cash flows. Plus, the public markets may not support an initial public

offering (IPO) five or six years from now, thus keeping venture capitalists from

harvesting their gains.

Venture capitalists typically value start-ups by estimating earnings five or so years in the

future, assuming that the company then will be taken public. They derive an IPO value by

taking the earnings in that final year, multiplied by the price-earnings multiple3 they

expect from the public markets at the time of sale. To compensate for the large risks and

uncertainties involved, venture capitalists use extraordinarily high discount rates,

sometimes as high as 75%.

Using high discount rates to adjust for risk and ambiguity can lead to misleading

valuations because the compounding effect of extremely high discount rates severely

penalizes cash flows in later years.

For example, at a 75% discount rate, a dollar in three years is worth 19 cents; in eight

years, only 1 cent. If you took the mathematical calculations of the venture capital

method literally, a five year delay of an IPO would reduce the net present value of a firm

by 95%!

2

The risk-free rate is that offered by an investment with no discernible risk, typically the rate paid by U.S. Treasury

bonds of comparable duration.

3

The price-earnings multiple is the value that the public markets place on the earnings of a company. It is computed by

observing the multiples paid for similar companies with comparable businesses and earnings streams.

2

By assuming that the risk at start-up remains extremely high in perpetuity, the venture

capital method rewards short-term speculative ventures that can reach the IPO stage

quickly, and harshly penalizes longer-term ventures.

Like the CAPM model, the venture capital method is little more than a series of guesses,

disguised in a framework that appears logically rigorous.

A discount rate can be dissected into three parts, each of which compensates an investor

for a portion of the risks he or she takes when trading cash on hand (value today) for the

rights to an uncertain stream of future cash flows.

The first part of a discount rate—the “real” rate of return—compensates investors for

putting money to work instead of spending it. Over the past three hundred years, the

world economy has grown at approximately 3%4 a year, generally varying between 2.5%

and 3.5%. In other words, this is the value we create as human beings by being willing to

defer gratification to invest in our future.

The second part of a discount rate is an adjustment for the expected rate of inflation.

Because governments debase the value of their currencies each year—by printing

banknotes whose value exceed the amount collected in taxes—each unit of currency is

expected to be worth less in the future than it is today. Over the past several hundred

years, inflation has averaged approximately 3% a year.5

The combination of real interest rates and inflationary expectations is called the nominal

rate, an interest rate equivalent to the “risk-free rate” in the CAPM method.

The third component of a discount rate compensates the investor for taking risk. It is the

premium over nominal returns that an investor should expect to receive for bearing the

risk of an investment. In the CAPM model, the risk is calculated based on the historical

instability of a public stock price. In the venture capital method, it is a large “fudge

factor” used to capture everything from the overconfidence of entrepreneurs to the

fickleness of public markets.

4

A 3% real rate may not seem impressive, but over the past 360 years, it has resulted in the construction of the United

States economy, showing the awesome power of compound interest.

5

Inflation rates are much more volatile than real discount rates; in extraordinary years, worldwide inflation has

exceeded 10%.

3

Warren Buffett’s 9% Discount Rate

The famous long-term investor Warren Buffett reportedly uses a 9% discount rate,

regardless of current interest rates, inflation expectations, or the risk associated with an

investment. On the surface this seems preposterous, especially since long-term interest

rates and inflation expectations fluctuate widely. Further inspection shows that wisdom

often comes in simple packages.

Buffett knows that over the long run, annual real returns and inflation have averaged

approximately 3% each. In using a 9% discount rate, Buffett is saying that in the long run

he believes that nominal rates will average 6% and he wants to make an additional 3%

return to compensate him for his investing genius.

Buffett uses a consistent discount rate to tell him when to invest and when to sit on the

sidelines. In “good times,” when inflation is low and too much money is chasing deals,

Buffett’s discount rate will be too high, and he will be unable to find any interesting

investments because others will outbid him.6

In times when inflation is high or money is hard to find, Buffett’s 9% discount rate will

lead him to be aggressive, and since there will be few other bidders, he will have his pick

of investments that give him the highest net present value at a 9% discount rate.

Staying with a 9% discount rate allows Buffett to avoid speculative booms and take

advantage of the inevitable speculative busts that follow.

Unlike with the venture capital method, by using only a small premium over real interest

rates and inflation, Buffett does not use discount rates as a proxy for risk. Instead, he

adjusts for risk by projecting more-accurate free cash flows, running multiple scenarios,

and using debt and options to make sure that in all but the worst-case scenarios, he is

likely to recover his investment.

Those who use the CAPM or the venture capital method are estimating risks from 30,000

feet, using analytical cleverness to avoid understanding the nuts and bolts of a business.

Buffett revels in the nuts and bolts, understanding in simple terms why customers buy,

how products are made and delivered, and how competitors can be kept at bay.

If Buffett can make a 6% real rate of return over a long period of time, he will own an

even larger piece of the world than he does now.

6

In 2005 Buffett reportedly held more than $48 billion in cash, signaling that he could find few attractive investments.

4

A Warning About Using A 9% Discount Rate

Remember that Warren Buffett has a lifelong track record of understanding the

fundamental risks of a business. He avoids businesses that he does not understand or that

do not allow him to adjust for the overconfidence of the forecaster.

If you use a 9% discount rate and are unable to adjust overly optimistic cash flows back

to reality, you will tend to overvalue opportunities. Buffett’s method is not an excuse to

blindly increase your valuation by using a low discount rate but instead is an admonition

to learn more about the customers, cost structure, and competitive environment of the

business you are studying.

Summary

venture capitalists use discount rates of 50% to 75% to value an opportunity. Could such

approaches be misguided?

There is a difference between cleverness and wisdom. Fancy theories and mathematical

formulas may make you feel smarter, but they are dangerous tools when used to avoid a

common-sense understanding of the opportunity you are analyzing.

Warren Buffett’s reported use of a 9% discount rate is simple, but not simplistic. It gives

him an unwavering sense of whether markets are exuberant or depressed and—provided

that his analysis of fundamental cash flows is sound—provides an accurate estimate of

value.

Understand the fundamentals of a business. Run multiple free cash flow projections. Use

convertible debt or other types of options to protect yourself from downside cases, and

invest only when the market is pessimistic about the future—and you can be wise, too.

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