The question of the appropriate discount rate inevitably arises when attempting to value a business as the present value of future cash flows. Here is an insight by Charlie Munger, gleaned during a Q&A session at the annual meeting of Daily Journal Corporation in February 2016:
…different businesses need different rates.
Q: How do you use the discount rate to calculate intrinsic value?
Munger: We don’t use numeric formulas that way. We take into account quality factors. It’s like a bridge hand, you have to think about a lot of things. There is never going to be a formula. If that worked, every mathematical person would be rich, but that’s not the way it works.
Q: But you value a company…
Munger: Opportunity cost is crucial, and the risk free rate is one factor.
Q: Do you use the same rate for different businesses?
Munger: The answer is no, of course not, different businesses need different rates. They all are viewed in terms of value, and they’re weighed one against another. But a person will pay more for a good business than for a lousy one. We really don’t want any lousy businesses anymore. We used to make money betting on reinventing lousy businesses and kind of wringing money out of them, but that is a really painful, difficult way to make money, especially if you’re already rich. We don’t do much of it anymore.
Sometimes we do it by accident because one of our businesses turns lousy, and in that case it’s like dealing with your relatives you can’t get rid of. We deal with those as best we can, but we’re out looking for new ones.
Listen to an audio recording of Charlie Munger’s remarks on discount rates.
The above excerpt is taken from the full meeting notes by Jesse Koltes.