Thinking about future returns

A question of discounting.

I’ve recently been thinking a lot about Discount rates as I try to develop my investment process and increase my expected future returns while decreasing risk via owning exclusively high-quality businesses with a heavy moat.

As a quick refresher: What is a discount rate? The most accurate way to (theoretically) value a stock is by doing a Discounted Cash Flow Analysis (DCF). This is done by assuming a future growth rate for the company's Free Cash Flows and then discounting it. There are models with widely varying levels of complexity, but they all have one thing in common: They use a discount rate, which is synonymous with the expected rate of return the investment should provide. I recently asked my Twitter audience which discount rate they use and the majority is using 10%. That is also what I use.

To give a bit more nuance, let’s look at my approach: Below you see an example of my Inverse DCF model I used in my recent article about Nemetschek NEM 0.00%↑, which I recently purchased. The difference between a normal and an inverse DCF is that an inverse DCF uses the current share price and calculates what growth rate the market assumes. I prefer this to traditional DCF models because it has fewer assumptions. It basically just views what the market expects.

I use a 10% discount and 3% perpetual growth rates. A what? A DCF goes on for a certain amount of years, in most cases (including mine) a 10-year timeframe. To model correctly, we need a growth rate “into eternity” at least in theory. Most people use something like the expected GDP of the country or something like this. I normally just use 3%. So discount and perpetual growth rates are really what we can change in our models.

The question arises if I should aim for higher than 10%, which should beat the market, but not by a large margin. Expecting higher returns should have a bigger margin of safety and a higher probability of a successful investment. The reason why I stick with 10% for now is that I try to mainly invest in high-quality businesses, often with predictable businesses, that I expect to compound for a long time. I hope that my 3% perpetual growth rate is conservative in many of these cases. The longer a company can maintain a higher growth rate, the more it can compound. The pictures from a post by my friend Leandro from Best Anchor Stocks illustrate this well.

The way I use my DCF models is to see if the assumed growth to achieve a 10% CAGR over a decade is reasonable. In the example of Nemetschek above, the 10-11% growth rate is in line with its projected industry growth rate. Because I expected Nemetschek to gain market share and do accretive M&A this looks like a good risk/reward to me. Base case I beat the market, bull case is much better.

To conclude this little ramble, I totally understand the arguments to use a 12 or 15% discount rate, but at least right now I am fine using 10% with reasonable assumptions. I plan to increase this discount rate as I develop as an investor and become more confident in my abilities. I hope this helped spark some thoughts for you and if it did please share how you use discount rates. Also share this post if you value in it.

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