In a previous article, I took a look at the strategy Warren Buffett has said he used to value stocks.
In the article, which you can find here, I highlighted some of Buffett’s previous comments on valuation and calculating a company’s cash flow figures, which can offer a roadmap to calculate intrinsic value.
“If you can tell me what all of the cash in and cash out of a business will be between now and judgment day, I can tell you, assuming I know the proper interest rate, what it is worth,” Buffett told students of Notre Dame in a series of lectures in spring 1991.
As the quote above states, there are two components: cash flows and the discount rate.
I’ve looked at the framework Buffett has used to compute cash flows. Here, I’m going to consider some of the Oracle’s comments regarding discount rates and look at how it would work in practice.
Warren Buffett on discount rates
Estimating the discount rate can be a hugely complicated process. There are formulas analysts use to compute these rates based on multiple inputs and factors such as company size, cash flow visibility, political stability, and financial stability of a company’s home country.
Buffett, it would appear, likes to keep things simple.
At the 1994 Berkshire annual meeting of shareholders, he explained that he wanted to stick with blue chips he knew and understood in America rather than trying to play with different figures. That way, Buffett explained, there would be no need to come up with any fancy formulas or models.
It would also reduce the chances of making a mistake. After all, the smaller the number of variables, the less chance there of something going wrong.
And when it came to the discount rate figure, Buffett said:
“I would say that in a world of 7% long-term bond rates that we would certainly want to think we were discounting future after-tax streams of cash at least a 10% rate. But that will depend on the certainty we feel about the business. The more certain we feel about a business, the closer we are willing to play it.”
This suggested that Buffett was happy with a discount rate of 3% above the risk free rate (the 10-year Treasury yield) for stocks he knew and understood well.
So, how would this work in practice?
I’m going to use Coca-Cola as an example.
Coca-Cola’s free cash flow has grown at a compound annual growth rate of 0.8% per annual for the past decade. In its last full financial year, the company reported free cash flow of $8.4 billion.
At the time of writing, the 10-year Treasury yield is 0.88%. I’m going to round this up to 0.9%. With a 3% margin that provides a discount rate of 3.9%.
Plugging all of the above into a discount cash flow model gives an implied valuation of just under $63.56 per share at a discount rate of 3.9%. At the current price of $48.81, that implies the stock may be undervalued at current levels. This is only a rough guide and should not be interpreted as investment advice.