Discount rates are so often talked about in the investing world, but what are they, and how should investors use them?
In layman’s terms, a discount rate (sometimes called a hurdle rate) is the minimum rate of return demanded by an investor of a proposed investment. It is a question of opportunity cost - if I can earn 2% by investing in U.S. Treasuries (which are essentially risk-free), then I will not invest in a company (which is not risk-free) which promises me an equivalent rate of return. In fact, I am unlikely to accept even a 3% rate of return from the business.
How do the pros use discount rates?
Warren Buffett (Trades, Portfolio) and Charlie Munger are fond of talking about discount rates because they form part of the foundation for their investment decisions. However, you may be surprised to learn that the Berkshire duo has never put together a spreadsheet to specifically quantify their discount rate - it’s not like they have a call every morning at 9am to discuss the matter! To them, it is enough to do a mental calculation of whether an investment is worth the trouble. To quote Buffett himself: “I know it sounds fuzzy, but it is fuzzy!”
Why not use a specific number?
What’s interesting here is Buffett’s willingness to accept uncertainty in what you would think is a business that demands precision. What he understands is that shackling oneself to a specific number in instances like these can lead to more harm than good. As Mungersaid at the 2007 Berkshire annual investor conference:
“Just because you can measure something and guess it doesn’t mean that it’s the controlling variable with what you’re dealing with in a messy world. I don’t think there’s any substitute for thinking about a whole lot of investment options and thinking about why one is better than another what the likely returns are from each, etc. The trouble with a hurdle rate concept - not that we don’t have one in a sense - is that it doesn’t work as well as a system of comparing things”.
Munger believes that applying mental flexibility and deciding what to invest in on an ad hoc basis is a much better system than trying to define a clear numerical line below which one cannot invest. I think this is quite similar to an idea I touched on in a previous piece about Munger’s desire to be a generalist rather than a specialist - it is much better to have a holistic view of all your investment options and to pick the best one, rather than being stuck in one static mindset.
What’s more, Buffett believes that in cases where the management of a company is allocating capital for internal reinvestment, the use of a clearly defined hurdle rate can incentivise project-leaders to fudge their numbers to come in just above it. In these cases, relying on a number rather than on common sense can mislead decision-makers. For these reasons, he and Munger prefer to use the eyeball test. It’s better to be approximately right than to be exactly wrong.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Warren Buffett: There Is a Big Difference Between a Great Stock and a Great Industry
- Investors Should Consider Adding Gold to Their Portfolios
- Warren Buffett and Charlie Munger Called the 2008 Crisis
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