In one of our blogs, we highlighted how our clients’ returns would have enhanced returns by more closely following a position-sizing optimization based on probability-weighted return. We also noted how the quality of the probability-weighted returns impacted the improvement generated by the optimization (garbage-in garbage-out). The return our clients calculate is the difference between the market’s valuation and the manager’s calculation of intrinsic value (probability-weighted return). Said another way, gaining a sense of the intrinsic value is the core task of a portfolio manager.

For managers that use discounted cash flow analysis to determine intrinsic value, the discount rate is one of the most subjective, yet important, inputs. For managers that do a scenarios analysis, we pointed out a straightforward approach that dramatically reduces subjectivity (June ‘18 blog). However, for those that don’t do scenario analysis, determining the discount rate can be substantially more complicated.

We’ve recently spent some time with Ryan Guttridge and his colleague Corry Bedwell of the University of Maryland and they have some interesting ideas on setting discount rates that I thought were worth sharing:

**Let’s Think about What Intrinsic Actually Means**

An intrinsic *property *is well defined in sciences such as chemistry. An intrinsic property* is an essential or inherent property of a system*. Said another way, an intrinsic property is internal to the system being evaluated like specific density is an intrinsic property of water. In contrast, an extrinsic property is not internally defined by the entity being evaluated. So, think about them this way:

Intrinsic – Totally independent of outside influence

Extrinsic – An influence outside the system

**Why We Discount – The Marshmallow Test**

Put a group of kids with a plate of marshmallow’s (or any other tasty treat) in a room and leave. What will happen? Chances are by the time you come back the treats will be gone. Why? Well, something now is better than something later. Ok so change the rules, offer the kids a deal. If they don’t eat the treat right away they will get another one at some later time, growing their supply of marshmallows. So, the deal from the kids perspective, I give up eating the marshmallow now and get two later. What makes it worth it? First, he has trust that the marshmallows will be delivered as promised. Second, the time he must wait for a reward can’t be too long, given the fact he can always eat the marshmallow now. In other words, the reward has to be large enough to overcome the opportunity cost of eating the marshmallow now. This is the classic economic definition of the logic of discounting. Forgo today’s marshmallow for two tomorrow.

**Investing – Bringing two separate but intrinsic concepts together**

Think about what goes through your head when you make an investment. You are going through the same steps described above. First, you will estimate the series of cash flows you expect the asset to provide (when are and how often are the marshmallows arriving). Second, you are going to decide how much you will pay for those cash flows (how badly do you want that marshmallow now). Each of these steps are independent but intrinsic.

However, according to the financial literature, determining an appropriate discount rate (i.e. the opportunity cost) isn’t straight forward. The efficient market hypothesis logically implies the correct discount rate for our intrinsic valuation models is the company’s weighted average cost of capital, WACC. Which is defined in the following way:

That is WACC is the portion of capital from equity plus the portion of capital from debt.

**WACC – A Tale of an Extrinsic Rate**

So, let’s take this apart -- our recommended discount rate is a function of capital ‘’we” have from equity and the amount of capital “we” have from debt. Right? This has at least two fundamental problems.

First, if the market is efficient, there is no reason for active management. However, there is a growing body of literature showing that while large swarths of the market can be considered efficient, there are pockets of inefficiency. So, if these inefficiencies are going to be taken advantage of, logically a discount rate that requires efficiency cannot be used.

Second, an active manager is required to have an independent sense of value. He is hired to find “mis-priced” assets. The only way to do that is to develop an independent view of the correct valuation (i.e. outside the market). So, what do we have that is independent of the Market? Think back to the marshmallow test. The value of the deal is a function of the opportunity cost (compensation for not buying something else) of your capital, and the intrinsic productivity (read cash flows) of the asset.

**What to do about Risk?**

One way to deal with this problem is to use scenario analysis as mentioned above. For those who don’t use scenario analysis, you need to focus on these three issues when calculating a discount rate: 1) Opportunity cost of capital (possibly provided by your benchmark), 2) the *average* cash flow level, and 3) its variation. Not only are these intrinsic to the system, but your analysis offers an independent sense of value. This, in turn, allows for the calculation of “edge” (the difference between Intrinsic Value and Market Value) and proper optimization. In our next post, we will expand on the calculation of an intrinsic discount rate using this method. In the meantime, feel free to check out our paper on the topic: https://arxiv.org/abs/1903.09683