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Calculating Present Value
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Calculating Present Value

Now that you know the theory behind an intrinsic value calculation, here's how you can do it in practice. To find the present value of a $100 future cash flow, divide that future cash flow by 1.0 plus the discount rate. Using a 10 percent discount rate, for example, a cash flow of $100 one year in the future is worth $100/1.10, or $90.91. A $100 cash flow two years in the future is worth $100/(1.10) , or $82.64. I n other words, $82.64 invested at 10 percent becomes $90.91 in a year and $100 in two years. Discount rates are really just interest rates that go backwards through time instead of forwards.

Fun with Discount Rates

Now that we have the formula down, we need to figure out what factors de­termine discount rates. How do we know whether to use 7 percent or 10 percent? From our previous example of the delayed vacation, we know that opportunity cost—or time value—is one factor and that the other big deter­minant of our discount rate is risk.

Unfortunately, there is no precise way to calculate the exact discount rate that you should use in a discounted cash flow (DCF) model, and academics have filled entire journal issues with nothing but discussions about the right way to estimate discount rates—but trust me, it's not a discussion in which you want to be involved.

Here's what you need to know for practical purposes: As interest rates in­crease, so will discount rates. As a firm's risk level increases, so will its discount rate. Let's put these two together. For interest rates, you can use a long-term average of Treasury rates as a reasonable proxy. (Remember, we use the interest rate on treasuries to represent opportunity costs because we're pretty certain that the government will pay us our promised interest.) In mid- 2003, tne average yield of the 10-year bond over the past decade was about 5.5 percent, so we'll use that. Because this isn't an exact science, you may want to use 5 percent or 6 percent.

Now for risk, which is an even less exact factor to measure. According to standard finance theorists, risk is the same thing as volatility, and the risk level of a company can be estimated simply by looking at how much its shares have bounced around relative to how much the market has bounced around. Thus, if a firm's shares suddenly drop from $30 to $20, this theory holds that the stock has just become much riskier.

We're not big fans of this definition of risk at Morningstar because "we think stocks that are cheap are generally less risky than stocks with high price tags. (This assumes that nothing dramatic has changed with the underlying business, which isn't always the case when a stock drops.) We think it's better to assess risk by looking at the company, rather than by looking at the stock, and that a firm's riskiness is determined by the likelihood that it "will or won't generate the cash flows that we're forecasting.

Why? Because "what the share price has done in the past may have little bearing on what cash flows the company generates in the future. We think it makes more sense to define risk as the chance of permanent capital impairment—in other words, the likelihood that our investment will be worth much less when we go to sell it than it is today. Here are some factors we think should be taken into account when estimating discount rates.

Size

Smaller firms are generally riskier than larger firms because they're more vul­nerable to adverse events. They also usually have less diversified product lines and customer bases.

Financial Leverage

Firms with more debt are generally riskier than firms with less debt because they have a higher proportion of fixed expenses (debt payments) relative to other expenses. Earnings will be better in good times, but worse in bad times, with an increased risk of financial distress. (Financial distress means that the firm is having trouble paying its debts.) Look at a firm's debt-to-equity ratio, interest coverage, and a few other factors to determine the degree of a company's risk from financial leverage.

Cyclicality

Is the firm in a cyclical industry (such as appliances or semiconductors) or a

stable industry (such as breakfast cereal or beer)? Because the cash flows of

cyclical firms are much tougher to forecast than stable firms, their level of risk

increases.

Management/Corporate Governance

This factor boils down to a simple question: How much do you trust the folks running the shop? Although it's rarely black or white, firms with pro­motional managers, managers "who draw egregious salaries, or who exhibit any of the other red flags covered in Chapter 7 are definitely riskier than companies with managers who don't display these traits.

Economic Moat

Does the firm have a wide moat, a narrow moat, or no economic moat? The stronger a firm's competitive advantage—that is, the wider its moat—the more likely it will be able to keep competitors at bay and generate a reliable stream of cash flows.

Complexity

The essence of risk is uncertainty, and it's tough to value what you can't see. Firms with extremely complex businesses or financial structures are riskier than simple, easy-to-understand firms because there's a greater chance that something unpleasant is hiding in a footnote that you missed. Even if you think management is as honest as the day is long and that the firm does a great job running its operations, it's wise to incorporate a complexity discount into your mental assessment of risk—unless you really want to memorize all 700 pages of the last io-k filing.

How should you incorporate all of these risk factors into a discount rate? As I said earlier, there's no right answer. At Morningstar, we use 10.5 percent as the discount rate for an average company based on the factors in the preceding list, and we create a distribution of discount rates based on whether firms are riskier or less risky than the average. As of mid-2003, firms such as Johnson & Johnson, Colgate, and Wal-Mart fall at the bottom of the range, at around 9 percent, whereas riskier firms—such as Micron Technology, JetBlue Airways, and E*Trade—top out at 13 percent to 15 percent.

The key is to pick a discount rate you're comfortable with. Don't worry about being exact—just think about whether the company you're evaluating is riskier or less risky than the average firm, along with how much riskier or less risky it is, and you'll be fine. In addition, remember that assigning discount rates is an inexact science—there is no "right" discount rate for a company.

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