What discount rate do you use in your valuations?

Hi guys, was hoping I could get some insight on this esp. from those buysiders at long only value shops

i currently work on the buy side focusing on resource sector companies, I don't think I've ever calculated a company's WACC outside of my MBA studies, we always use a 10% discount rate. The generalists in my shop do the same thing, however they always debate the merits of using an arbitrary 10%, but at the end of the day the end up using 10% for valuations with the arguement that it allows them to compares valuations for different companies in the same sector

Currently I'm evaluating a Company outside the resource sector, initially when I ran the valuation I used a 10% discount rate...just because that's what I always use. I calculated the Company's WACC, and it comes out to just under 6%...this makes a huge difference to my valuation. Obviously there's a lot more rational to using WACC over an arbitrary 10%, just wondering how other people look at non-resource companies

Thanks

Comments (18)

Sep 1, 2014

Some options;

1) Calculate the WACC at t0 and use the same WACC for every future cash flow (in your specific case the 6% one).

2) Use a rolling WACC. So currently most WACC's will be really low due to historically low interest rates and risk premiums but one might expect these to rise in the future. So an option is to adjust the WACC upwards for years further in the future (Aswath Damodaran often employs this method in his valuations).

3) Just take a number you feel fairly represents the riskiness of the cash flows. Peter Lynch (his book One up on Wall Street is amazing btw) advocated this approach. He said he often just takes a rate between 9 and 15% and his choice is dependent upon his 'idea' (obviously a vague construct but yea) of the riskiness of the cash flows.

I am actually quite a fan of option 3 for the WACC is largely dependent upon the CAPM, a scientific model that got raped personally by the investors from Graham-Dodd's Ville.

Sep 1, 2014

thanks for the response,

Actually i was punching in the wrong beta, so my wacc actually works out to 9.6%, which is pretty close to the 10% i was using, and i'll round that up to 10% anyways. However, this is something I've struggled with since i see the guys around me using a 10% discount rate for every company the evaluate - i think this is too punitive for stable companies with dependable FCF generation

I too feel most comfortable with option (3), and will apply that along with WACC and common sense going fwd

I've never hear of using a rolling wacc, in today's low i-rate environment that makes a lot of sense.

thanks!

Sep 2, 2014

9%: "It is better to be approximately right than precisely wrong. - Buffet"

No bias, no ego and no emotion

Sep 4, 2014

This is where valuation is obviously more of an art than a science. Talking about the right discount rate is always BS because people invariably have an idea of what they want the valuation to be and end up changing the rate to accomodate their number. Because of this, I usually treat the discount rate as an output instead of an input and ask myself if it makes sense among industry peers. If so, your work is done.

Sep 14, 2014
arya180:

This is where valuation is obviously more of an art than a science. Talking about the right discount rate is always BS because people invariably have an idea of what they want the valuation to be and end up changing the rate to accomodate their number. Because of this, I usually treat the discount rate as an output instead of an input and ask myself if it makes sense among industry peers. If so, your work is done.

Calculating discount rates is not where "valuation is more of an art than a science." This is what poor analysts tell themselves when they're too lazy to understand what they're actually doing. I'm not saying the discount rate calculation is ever precise, i.e., that one can, with complete certainty, determine future cash flow volatility. What I'm saying is that there are better approximations, worse approximations, much better approximations and much worse approximations.

To respond to the OP's question - One could use the same discount rate when evaluating a set of comparables since, in the long run, the riskiness of their operations should be identical insofar as the firms in question are true comparables/operate within in the same industry and face the same exogenous pressures. But if this is all you're doing, then why do a DCF at all? Why not just look at profitability and PEG ratios?

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Oct 7, 2014

Hello,
I am also using discount 6% for every valuation.

Thnks.......

Oct 7, 2014

he's looking for a few things:

basic understanding of current debt pricing
current understanding of cost of equity calculations ie industry risk fundementals.

I would assume a 8%, all-in, senior debt cost of capital for energy, 9% for telecom and 10% for internet, for well established companies as the assets used to secure these assets gets smaller as the pricing goes up.

His main target in my opinion is your understanding of the Beta for each of those industries.

If you have good reason's why each industry has more debt vs equity good, if not stick with a 50/50.

At the end it comes down to the relative volatility of the industry in relation to the market with beta (from lowest to highest) energy, telecom, internet.

Oct 7, 2014

Generally speaking, this is how I would approach this question:

Internet Company: Lack of cash flows means no cash-flow/asset based lending, capital structure is going to be made up of predominantly equity which is going to be the most expensive. Use CAPM to calculate cost of equity and use that was your WACC (assuming no debt)...I am not getting into the CAPM calculation but its pretty straightforward.

Telecom Copmany: Has assets, and based on cash flow situation, for the mature companies like ATT and Verizon this is pretty strong so obviously there would be debt on the books so the WACC is going to be lower than that of the Internet Company.

Energy Company: I consider energy to be something that is going to be cut back on last by consumers, so essentially given constant demand (public utility company like Con-Ed), they've got more debt than equity since they can get it cheaper...so its going to be the lowest of the three.

Thats my take on it. Its a fun question in the sense that you can get really creative with it and im sure some other people on here will get creative and post responses.

Oct 7, 2014

Hello,

In both cases you need to use the target cost of capital. Many bankers get this wrong. You always value the target using its own risk profile characteristics. It's in the synergy calculation that benefits of scale, more favorable optimal capital structure, etc should be quantified and allocated to buyer and seller (the proportion of how much is allocated to buyer vs seller depends on whether the benefit the target brings are unique).

In the second example you describe, where the acquirer is contemplating only acquiring certain assets, i am assuming you are buying the assets free and clear of any debt, which is why you're pondering using the acquirer WACC, correct?

In this case, you would value those assets on a standalone basis using a WACC that equals the target's cost of equity (using an unlevered beta). The little caveat there is that if the assets being acquired have a very different risk/cash flow profile from the remaining assets, then taking the full company's beta is still not super accurate, but you are on much more defensible ground than using the acquirer's WACC.

Matan Feldman
Founder, Wall Street Prep
Learn Financial Modeling

Oct 7, 2014

In any case, you need to use the discount rate that captures the risks associated with the cash flows you are discounting.

In the first case the wacc should capture the risks associated with the target company.

In the second case you need to use a wacc that reflects the risk associated with the set of assets you are acquiring (probably using betas and debt to equity ratios of a set of companies that closely reflect a stand alone operation similar to the acquired assets).

Oct 7, 2014

^ Agreed. If a good comp set exists, this is a good approach.

Matan Feldman
Founder, Wall Street Prep
Learn Financial Modeling

Oct 7, 2014

Thank you! That is very helpful.

So the discount rate should always be constructed to mirror the profile of what is being acquired?
I suppose it's easy when trying to acquire an entire company - since you can just calculate the WACC of the target, but what happens if you are acquiring a division of a conglomerate (such as GE?) The firm's overall WACC would not reflect the division's WACC. I suppose one way is to look at comparables and find the appropriate beta to formulate the cost of equity, but is there a better way? Also, for the cost of debt, would I just take a rough yield on the division's debt?

Thanks

Oct 7, 2014

What you try to do is to find comparable publicly traded companies that closely resemble the "division" you want to value. Since usually divisions focus on specific businesses, ideally you will try to find "pure players"....publicly traded companies that only have only one business (similar to the division u are trying to value). Now, this is easier to say than to do. Usually pure players are hard to find and you might have to settle with a set of companies that are close enough to your company (highly subjective).

For the debt I would suggest you to compare both the company's debt to the debt of the set of comps you selected for your beta calculations. If those two are similar you could go with either. If those to are far apart then u need to understand why there is a difference before you take your decision; but given that you are already using the comps for your beta you should probably use the same set to estimate the cost of debt, as this would better reflect a stand alone operation. Remember that divisions of large corporations might benefit from favorable terms just because of their parent companies, which might not be reflecting the risk associated with the division. Also, debt might be at the holding company level, which might give you a wrong indication of the correct debt to equity ratio.

Oct 7, 2014

Thanks!

Oct 7, 2014
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