RBD - Restaurant Brands

[Sauce]

They are the same of course

But in this discussion the $1m cash flow is a forecast / projection / calculation ... and the problem / question is what would pay to get a forecasted $1m from Grandma's Trotters and how much for the Coke $1m

Some analysts don't use WACC at all ...... they do cashflows under many scenarios and by applying probabilities against each come up with an expected value of the cash flows and use those as the basis of their valuations

Note the words applying probabilities and expected ... see it all really is a big guess (OK best guess / judgement) ... just like the equity premium used in WACC calculations is and just like what Warren might use

So back to Grandma and Coke ... what is the likliehood of those $1m cash flows actually be achieved

Nicely put. Considering how drastically just 1% each side of your discount rate can alter valuations one might wonder if there is any point at all!

As usual Buffett and Mungers wisdom seems most rational:

Only commit funds if a large margin of safety exists to your subjective valuation. And its better to be approximately right than precisely wrong.

Cheers

Sauce

[Sauce]

Oh I thought we were talking about discounted cashflows. Stupid me.

I'd pay more for Coke's cahflow and less for Grandmas. But that's margin of safety. Bigger margin for Grandma aye.

Bingo. So therefore you could have a lower discount rate for coke, and a higher discount rate for grandmas.

[h2so4]

Why? Their cashflows are exactly the same. If you have a lower discount for Coke and a higher discount for Grandma then you wont be able to compare the two.

[Sauce]

Why? Their cashflows are exactly the same. If you have a lower discount for Coke and a higher discount for Grandma then you wont be able to compare the two.

Their cashflows are exactly the same, but you already hit the nail on the head. You would pay more for cokes cashflows due to its greater certainty, and so would others, so you could discount cokes cashflows back to todays value at a lower rate of return (discount rate). This reflects that you are happy to pay more for those cashflows in a higher valuation of them.

By using a higher discount rate for Grandmas, you are building in more conservatism due to the risk. In other words you are demanding a higher rate of return.

i.e. you are paying less for the cashflows of grandmas than you would for Coke by using different discount rates in your valuation, exactly as you said you would.

As Winner said:

what is the likliehood of those $1m cash flows actually be achieved

You have already correctly implied they are not strictly comparable due to differences in quality, so therefore to compare Grandmas & Coke as potential places for your hard earned cash, you actually require different discount rates for each. I think this is partly the point. You actually make them more comparable as a potential investment.

Regards,

Sauce

P.s. Thinking of a discount rate as an investors "required rate of return" might be helpful. If investors are willing to pay more for certainty, then it makes sense to me that a lower discount rate could be used for more certain cashflows and a higher discount rate could be used for less certain cashflows.

[h2so4]

Sauce you are right, I concede I concede I concede.

It seems to me that you are changing the discount rate to fit the valuation.

I will leave you with a quote from Buffett.

"Don't use different discount rates for different businesses...it doesn't really matter what rate you use as long as you are being intellectually honest and conservative about future cash flows."

[Sauce]

Sauce you are right, I concede I concede I concede.

It seems to me that you are changing the discount rate to fit the valuation.

I will leave you with a quote from Buffett.

"Don’t use different discount rates for different businesses…it doesn’t really matter what rate you use as long as you are being intellectually honest and conservative about future cash flows."

Heh thanks for this h2

Ok Maybe Buffett doesn't. But I think my explanation is consistent with why people generally do use different discount rates for different companies.

I certainly remember reading somewhere that Buffett did not think it was correct thinking to substitute a high discount rate as your margin of safety. But theres no doubt that using a higher discount rate lowers the valuation and therefore makes it more conservative (generally a good thing).

Cheers

[h2so4]

Heh thanks for this h2

Ok Maybe Buffett doesn't. But I think my explanation is consistent with why people generally do use different discount rates for different companies.

I certainly remember reading somewhere that Buffett did not think it was correct thinking to substitute a high discount rate as your margin of safety. But theres no doubt that using a higher discount rate lowers the valuation and therefore makes it more conservative (generally a good thing).

Cheers

Yes you are right.

[gregrday]

Hi Snoopy

sorry, inflation rate should have been "growth rate of economy"... was looking at some inflation calculations and answered in a hurry. So, my statement should have been "long term companies cannot grow faster than the growth rate of the economy, and will probably grow less than that".

so... the question is, what is long term? In DCF, long term is measured as... infinity. So, a company can have a high growth period, but for the terminal calculation, the growth rate <= growth rate in economy. So the WACC doesnt need to be higher than the growth rate in the 'short' (ie, non-infinity) term.

not sure if this helps, or hinders!
cheers
Greg

[gregrday]

@Sauce,

my understanding of beta is its fundamentally nothing to do with shareprice, but based on the efficient market hypothesis (bull$#!t), the shareprice always reflects correct value, and therefore variations in shareprice are supposed to represent real changes in value. When in fact they appear to reflect ... a whole lot of noise.

Damodaran suggests that betas consist of 3 variables. 1. The type of business, 2. Operating leverage, and 3. Financial leverage (debt-to-equity). So from 1., cyclical companies are more prone to reacting to external market conditions, so higher beta. 2., Operating leverage is fixed costs/total costs. The higher those fixed costs, the less... flexibility the firm has, so higher beta. 3... higher debt leverage means higher variability in income (like trading on margin!).

I'm not quite at the point of estimating my own betas, but might be fun on a rainy afternoon!
cheers
Greg

[Sauce]

@Sauce,

my understanding of beta is its fundamentally nothing to do with shareprice, but based on the efficient market hypothesis (bull$#!t), the shareprice always reflects correct value, and therefore variations in shareprice are supposed to represent real changes in value. When in fact they appear to reflect ... a whole lot of noise.

Damodaran suggests that betas consist of 3 variables. 1. The type of business, 2. Operating leverage, and 3. Financial leverage (debt-to-equity). So from 1., cyclical companies are more prone to reacting to external market conditions, so higher beta. 2., Operating leverage is fixed costs/total costs. The higher those fixed costs, the less... flexibility the firm has, so higher beta. 3... higher debt leverage means higher variability in income (like trading on margin!).

I'm not quite at the point of estimating my own betas, but might be fun on a rainy afternoon!
cheers
Greg

Hi Greg,

Thanks for this. I can see how calculating a WACC might be interesting as an academic exercise. It would certainly be beyond my ability to do.

I have spent a lot of time reading Damodaran's essays on valuation (with only fractional understanding!), he is a guru for sure, but my hunch is that complicated WACC calculations are not any more useful than the somewhat more practical method of simply choosing the figure you believe is the relevant rate of return for that business.

If you are interested in Buffetts methodologies (I know, Buffett's ideas are thrashed to death) you might find this interview with Alice Schroeder interesting:

http://www.youtube.com/watch?v=PnTm2F6kiRQ

Alice was given unfettered access to all his files and notes on every Berkshire and partnership investment and spent 2000 hours with Buffett when writing his biography. She does not believe buffet performs any forecasting or DCF valuation at all when making investment decisions, contrary to what most people think, and provides an interesting example in this seminar.

Regards,

Sauce