How Warren Buffett and Charlie Munger Discount Future Cash Flows
By: Mike Berner
Tags: Finance, Investing, Business, Stock Market, Warren Buffett

How Warren Buffett and Charlie Munger Discount Future Cash Flows

Hint: They don’t do it like Wall Street

artwork by author

If there’s one subject that confuses finance students (and grownup investors) more than any other, it’s discounting future cash flows.

Discounted cash flow (DCF) models are the foundation of modern financial analysis. The basic idea behind discounting is that a dollar today is worth more than a dollar in the future.

If you could somehow figure out how much cash a company would generate over its entire lifetime and “discount” those future dollars back to the present day, you would know how much the company is worth.

Warren Buffett often invokes Aesop in explaining the concept:

The formula for value investing was handed down from 600 B.C. by a guy named Aesop. A bird in the hand is worth two in the bush.

Of course, Aesop forgot to mention a few other elements.

How many birds are in the bush? When are you going to get them out? What is the discount (risk-free) rate?

Wall Street analysts get paid a lot of money to answer these questions. They build complex DCF models with many variables, ultimately arriving at a precise figure of what the business is worth (it’s almost like they’re trying to justify their salaries…).

Buffett and business partner Charlie Munger look at discounting differently.

Owing to its technicality, DCF doesn’t come up too often during interviews with the investing legends. What we know about their views can be pieced together from nuggets of wisdom that they’ve spread over the years, usually at Berkshire Hathaway annual meetings.

Perhaps unsurprisingly, their DCF method is far simpler than the rest of Wall Street.

False Sense of Precision

The DCF models that I learned in business school trace their roots to academia. Buffett and Munger have been vocal in their criticism of academic finance, which Buffett refers to as the “priesthood.”

The exact figures spit out by models cloak the analysis with a certain mathematical legitimacy. Buffett once quipped that investors should “beware of geeks bearing formulas.”

Munger: Some of the worst business decisions I’ve seen came with detailed analysis. The higher math was false precision. They do that in business schools, because they’ve got to do something. Buffett: The priesthood has to look like they know more than “a bird in the hand.” You won’t get tenure if you say “a bird in the hand.” False precision is totally crazy. The markets saw it in the Long-Term Capital Management [hedge fund] in 1998. It only happens to people with high IQs.

While Buffett accepts the principle of discounting cash flows, Munger says that he has never seen him perform a formal DCF analysis.

Munger: Warren often talks about these discounted cash flows, but I’ve never seen him do one. If it isn’t perfectly obvious that it’s going to work out well if you do the calculation, then he tends to go on to the next idea. Buffett: It’s true. If [the value of a company] doesn’t just scream out at you, it’s too close.

Buffett once described reading an annual report for PetroChina back in the mid-2000s. Going through the filing, he felt that the company was worth at least $100 billion (the market valuation was $35 billion).

No spreadsheets, no formulas, no calculations.

For experienced investors like Buffett and Munger, spotting a great opportunity is more a case of pattern recognition. Just as a great chess master can glance at a random board and instantly see the endgame, they can read an annual report and know right away if the company is undervalued.

In some respects, investing is more of a qualitative exercise. The real trick is judging whether or not those cash flows will actually materialize, which has nothing to do with an Excel spreadsheet. That is where the science and art of investing blend together. Many high-IQ people find it easier to simply ignore the qualitative element.

Oh, and that PetroChina investment? Buffett made eight times his money on that bet — a $3.5 billion profit.

Using the Risk-Free Rate

Most investors try to account for risk by fiddling with the discount rate. Buffett doesn’t believe in that approach.

In the first place, Buffett thinks it only makes sense to “deal with things about which we are quite certain.” He is only interested in opportunities where the probability of actually getting those future cash flows is as close to 100 percent as possible. When investors protect against downside and reduce risk, it follows that they should use a lower discount rate.

Buffett: In a world of 7% long-term bond rates, we’d certainly want to think we were discounting the after-tax stream of cash at a rate of at least 10%. But that will depend on the certainty that we feel about the business. The more certain we feel about the business, the closer we’re willing to play. We have to feel pretty certain about anything before we’re even interested at all. But there are still degrees of certainty. If we thought we were getting a stream of cash over the thirty years that we felt extremely certain about, we’d use a discount rate that would be somewhat less than if it were one where we expected surprises or where we thought there were a greater possibility of surprises.

Moreover, using a single discount rate allows Buffett to compare the many investing opportunities that cross his desk every day.

Buffett: In order to calculate intrinsic value, you take those cash flows that you expect to be generated and you discount them back to their present value — in our case, at the long-term Treasury rate. And that discount rate doesn’t pay you as high a rate as it needs to. But you can use the resulting present value figure that you get by discounting your cash flows back at the long-term Treasury rate as a common yardstick just to have a standard of measurement across all businesses.

Rather than include a “risk premium” in his discount rate, he simply buys businesses at a large discount from calculated intrinsic value.

Shareholder: Following up on that other question — if you don’t adjust for risk by using higher discount rates, how do you adjust for risk — or do you? Buffett: Well, we adjust by simply trying to buy it at a big discount from the present value calculated using the risk-free interest rate. So if interest rates are 7% and we discount it back at 7% — which Charlie says I never do anyway, which is correct — then we’d require a substantial discount from that present value figure in order to warrant buying it.

In any case, Buffett and Munger are dismissive of the idea that one can even ascertain the cost of capital. Munger, in particular, has made no secret of his disdain for academia’s thoughts on the matter. In his view, it all comes back to your personal opportunity cost.

Munger: In the real world, you uncover an opportunity, and then you compare other opportunities with that. And you only invest in the most attractive opportunities. That’s your opportunity cost. That’s what you learn in freshman economics. The game hasn’t changed at all. That’s why Modern Portfolio Theory is so asinine.

As Munger points out, an investor never evaluates an asset in isolation.

Munger: The trouble isn’t that we don’t have a [a hurdle rate] — we sort of do — but it interferes with logical comparison. If I know I have something that yields 8% for sure, and something else came along at 7%, I’d reject it instantly. It’s like the mail-order-bride firm offering a bride who has AIDS — I don’t need to waste a moment considering it. Everything is a function of opportunity cost.

Or, even more succinctly:

Munger: I’ve never heard an intelligent discussion on cost of capital.

One of Buffett’s great strengths is his ability to say “no,” even to otherwise attractive business opportunities. He refuses to jump into something new unless he thinks he can get even better return than what he judges as the best investment at the moment.

When investors employ drastically different discount rates for different businesses, there’s no basis for comparison.

A Few Caveats

Although Buffett has always remained modest and self-deprecating about his investing prowess, there is no question that he is a man of exceptional intelligence.

In her biography The Snowball, Alice Schroeder writes how Buffett would often perform obnoxious feats of memory during his college years. The young Buffett both impressed and annoyed his professors by quoting long passages of their own work verbatim.

His mathematical ability is also said to be extraordinary. In The Warren Buffett Portfolio, Robert Hagstrom describes an instance where a Berkshire Hathaway shareholder asked Buffett if ever used a calculator. Buffett replied that he had not, insisting that his talent was simply “number sense.”

As a test, the investor asked Buffett on the spot if he knew the answer to 99 times 99.

“9,801,” he replied.

Apparently not satisfied, the investor pressed on. What’s the annual rate of return for a painting that goes from $250 to $50 million in one hundred years? Again, Buffett replied instantly.

“13 percent.”

When asked by the astonished investor how he did it, Buffett answered that anyone could just look at a compound interest table (as Hagstrom asks rhetorically, “should we deduce that he’s a walking interest table?”)

Without the advantage of such raw genius, most investors can’t be faulted for using simple spreadsheets to compute present value. Not everyone can be Warren Buffett — otherwise, we would all be billionaires.

Nevertheless, there is a lot to be said for eschewing the complex models and esoteric concepts that are common in academia and professional investment analysis.