How Warren Buffett and Charlie Munger Discount Future Cash Flows (2024)

FAQs

How Warren Buffett and Charlie Munger Discount Future Cash Flows? ›

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.

The discounted cash flow (DCF) formula is equal to the sum of the cash flow in each period divided by one plus the discount rate (WACC) raised to the power of the period number.

Buffett invests only in a business whose future earnings are predictable to a high degree of certainty. Companies with predictable earnings have good business economics and produce cash that can be reinvested or paid out to shareholders.

In corporate finance, a discount rate is the rate of return used to discount future cash flows back to their present value. This rate is often a company's Weighted Average Cost of Capital (WACC), required rate of return, or the hurdle rate that investors expect to earn relative to the risk of the investment.

Munger's salary and compensation as Vice Chairman of Berkshire Hathaway are lower than Buffett's as CEO. The impact of philanthropy: Munger is known for his philanthropy and has donated millions of dollars to various charitable causes throughout his lifetime. This generosity has likely impacted his net worth.

Since money in the future is worth less than money today, you reduce the present value of each of these cash flows by your 10% discount rate.

Example of Discounted Cash Flow

If a person owns $10,000 now and invests it at an interest rate of 10%, then she will have earned $1,000 by having use of the money for one year. If she were instead to not have access to that cash for one year, then she would lose the $1,000 of interest income.

Buffett: “We don't discount the future cash flows at 9% or 10%; we use the U.S. treasury rate. We try to deal with things about which we are quite certain. You can't compensate for risk by using a high discount rate.”

Warren Buffett uses the U.S. 10-year Treasury rate as the discount rate, as described below: "And once you've estimated future cash inflows and outflows, what interest rate do you use to discount that number back to arrive at a present value?

Warren Buffett's investment strategy has remained relatively consistent over the decades, centered around the principle of value investing. This approach involves finding undervalued companies with strong potential for growth and investing in them for the long term.

What is the discounting of future cash flows from an investment opportunity called? ›

The discount rate, often called the “cost of capital”, reflects the necessary return of the investment given the riskiness of its future cash flows.

Discounted vs Undiscounted Cash Flows

The time value of money is considered in discounted cash flows and thus is highly accurate. Undiscounted cash flows do not account for the time value of money and are less accurate. Undiscounted cash flows are not used in investment appraisal.

Reinvestment risk is the chance that cash flows received from an investment will earn less when put to use in a new investment. Callable bonds are especially vulnerable to reinvestment risk because these bonds are typically redeemed when interest rates decline.

Buffett has made his fortune by relying on the time-tested rules of value investing, meaning finding high-quality companies at fair market valuations.

Charles Thomas Munger (born January 1, 1924) is an American businessman, investor, and philanthropist. He is vice chairman of Berkshire Hathaway, the conglomerate controlled by Warren Buffett; Buffett has described Munger as his closest partner and right-hand man.

First, positive rates of inflation diminish the purchasing power of dollars over time. Second, dollars can be invested today, earning a positive rate of return. Third, there is uncertainty surrounding the ability to obtain promised future income.

Cash Discount Example

An example of a typical cash discount is a seller who offers a 2% discount on an invoice due in 30 days if the buyer pays within the first 10 days of receiving the invoice. Giving the buyer a small cash discount would benefit the seller as it would allow her to access the cash sooner.

Example of Discounted Future Earnings

For example, consider a firm that expects to generate the following earnings stream over the next five years. The terminal value in Year 5 is based on a multiple of 10 times that year's earnings. Using a discount rate of 10%, the present value of the firm is $657,378.72.

First, he studies what he refers to as "owner's earnings." This is essentially the cash flow available to shareholders, technically known as free cash flow-to-equity (FCFE). Buffett defines this metric as net income plus depreciation, minus any capital expenditures (CAPX) and working capital (W/C) costs.

Does Warren Buffett use NPV? ›

And how does Warren Buffett evaluate investment opportunities? He uses net present value (NPV). While I can't promise you'll be the next Warren Buffet, I can tell you more about net present value and how it's used to identify great investments. Let's dive in.

Buffett uses the average rate of return on equity and average retention ratio (1 - average payout ratio) to calculate the sustainable growth rate [ ROE * ( 1 - payout ratio)].

Buffett's goal is not to brutalize the other party and make sure he wins every percentage point. He wants to be consistently good, and trying to dominate every deal just isn't necessary. "Don't try and win every [percentage] point. Make decent deals and they add up over time."

The Rule of 72 is a simple way to determine how long an investment will take to double given a fixed annual rate of interest. By dividing 72 by the annual rate of return, investors obtain a rough estimate of how many years it will take for the initial investment to duplicate itself.

Also, the market may be fair valued if the ratio falls between 75% and 90%, and modestly overvalued if it falls within the range of 90 and 115%. The stock market capitalization-to-GDP ratio is also known as the Buffett Indicator—after investor Warren Buffett, who popularized its use.

Warren Buffett once said, “The first rule of an investment is don't lose [money]. And the second rule of an investment is don't forget the first rule. And that's all the rules there are.”

What is future cash flow? The future cash flow is all income and expenditure that a company expects in a future period. A forecasting period of several days, several months or even several years can be assumed.

What are the most used techniques in discounting cash flows? ›

There are mainly two types of DCF techniques viz… Net Present Value [NPV] and Internal Rate of Return [IRR].

Most finance courses espouse the gospel of discounted cash flow (DCF) analysis as the preferred valuation methodology for all cash flow-generating assets. In theory (and in college final examinations), this technique works great. In practice, however, DCF can be difficult to apply in evaluating equities.

Running regular cash flow projections is important because it can help you steer your business toward the future. Rather than making critical plans based on present circ*mstances, cash flow projections use historical data to help you make a plan for the future, which can be more accurate.

Decrease in Net Income

If revenues decline or costs increase, with the resulting factor of a decrease in net income, this will result in a decrease in cash flow from operating activities.

The highest risk investments are cryptocurrency, individual stocks, private companies, peer-to-peer lending, hedge funds and private equity funds. High-risk, volatile investments may bring high rewards, or they may bring high loss.

“Price is what you pay, value is what you get.” This famous Buffett quote strikes at the heart of the “value investor” approach and reveals the secret of how Buffett made his fortune.

Charlie Munger's net worth is estimated to be $2.3 billion as of 2023. Over 90% of Munger's fortune sits in shares of Berkshire Hathaway.

'Billionaire Stocks': Bill Gates, Berkshire Hathaway (BRK.B)

The natural stock pick held by the world's wealthiest person is Microsoft (NASDAQ:MSFT), the giant tech company Bill Gates co-founded with Paul Allen in 1975. Gates still owns almost 103 million shares of the company worth $15.4 billion.

Integrity – Buffett has been working with Munger for around 54 years now. That's a testament to Munger's honesty, integrity, and authenticity. This is important for an investor indirectly, as integrity is also about facing problems out in the open.

Munger's salary and compensation as Vice Chairman of Berkshire Hathaway are lower than Buffett's as CEO. The impact of philanthropy: Munger is known for his philanthropy and has donated millions of dollars to various charitable causes throughout his lifetime. This generosity has likely impacted his net worth.

How does Warren Buffet decide what companies to invest in? ›

As passive investors, Buffett and Munger seek out companies that seem to be trading for less than their intrinsic value. While there's no universal measure of value, companies with long-lasting earning potential tend to have consistent earnings, good cash flow and a low amount of debt.

Berkshire Hathaway saw a 19.8% compounded annual gain from 1965 to 2022, compared to 9.9% for the S&P 500 Index.

Warren Buffett is perhaps the best example of the power of long-term compounding. Buffett uses compound interest, dividend reinvestment, and the power of constantly reinvesting the operating cash flow generated by Berkshire's businesses to his advantage.

Warren Buffett's investment strategy has remained relatively consistent over the decades, centered around the principle of value investing. This approach involves finding undervalued companies with strong potential for growth and investing in them for the long term.

The idea behind NPV is to project all of the future cash inflows and outflows associated with an investment, discount all those future cash flows to the present day, and then add them together. The resulting number after adding all the positive and negative cash flows together is the investment's NPV.

Net Present Value (NPV) is the value of all future cash flows (positive and negative) over the entire life of an investment discounted to the present.

Present value (PV) is the current value of a future sum of money or stream of cash flow given a specified rate of return. Meanwhile, net present value (NPV) is the difference between the present value of cash inflows and the present value of cash outflows over a period of time.

Discounted cash flow is a valuation technique that uses expected future cash flows, in conjunction with a discount rate, to estimate the present fair value of an investment.

IRR is the discount rate for which the net present value (NPV) equals zero (when time-adjusted future cash flows equal the initial investment).